Making the Most of Your Incentive Stock Options While Avoiding the Traps

Stock options offered as an incentive by employers have grown in popularity over the last several years. Employees fortunate enough to receive stock options have a tremendous opportunity to boost their financial position. However, managing them for optimal benefit can be extremely challenging. It takes just one misstep to turn what should be a significant financial reward into a terrible dream.

While stock option planning should be based on individual circumstances, here are some guidelines to better understand them, how they work, and what to consider when holding them.

What Exactly is an Incentive Stock Option?

Incentive stock options (ISO) are a form of additional compensation granted to employees, typically based on performance. When granted an ISO, employees can purchase the company’s stock below the market price after exercising it. There are no tax consequences when receiving an ISO (except in cases of alternative minimum tax), only upon selling the stock. If held for more than a year, stock profits are taxed as long-term capital gains.

Stock Options in the Context of Your Financial Goals

The most significant decisions you need to make are when to exercise your options and sell the stock. Understanding the value of your options and how a potential stock sale aligns with your financial goals helps clarify those decisions. Having specific goals for the use of proceeds can help you determine how much stock to sell and when. It will also help you track their expiration dates. It is essential to do some tax planning, such as spreading stock sales over a few years to minimize taxes.

How Stock Options Work

The exercise and vesting rules for stock options vary. Some plans require a vesting period of up to a year before stock options may be exercised. Others offer options that can be exercised immediately but include specific timeframes for when you can sell the stock. It’s especially important to know the rules if you plan on leaving your employer at some point. Some plans require you to exercise vested options within three months of termination, while others may rescind options if you leave to join a direct competitor.

When to Exercise Your Stock Options

Ideally, you should hold onto your stock options as long as your company’s stock is performing well and has a solid outlook. As the stock value rises, the value of your options increases. However, if the value of your stock options represents more than 25 percent of your total net worth, you may want to consider selling a portion of your holding and diversifying your portfolio. Too much exposure to any one stock increases your risk.

Beware of AMT

Though there are no ordinary income tax consequences for receiving and holding ISOs, you must beware of the dreaded alternative minimum tax (AMT) once you exercise them. If you keep your shares for more than a year to qualify for the capital gains tax, the AMT calculation looks at the spread between your ISO exercise price and the stock’s current market price, regardless of whether you sell your shares. Calculating your AMT requires you to add back a number of standard deductions and then pay the higher tax. The AMT calculation can be very tricky and can sneak up on you if you aren’t prepared.

Generally, you should be tracking your income relative to the tax brackets. If an increase in the value of your stock options pushes you into a higher bracket, you determine if you should exercise some options to delay the tax into future years.

You Don’t Have to go it Alone

You should be able to get some educational materials on managing ISOs from your company’s HR department. However, to optimize your benefit and eliminate the possibility of any missteps, it would be essential to work with a financial advisor who can guide you through all the variables and tax implications to make the best decisions for your circumstances.