If you’ve been awarded incentive stock options (ISOs), there’s a lot that you need to know to take advantage of their full potential. ISOs give you the right to purchase shares of stock at a predetermined price according to a vesting schedule. They’re exclusively given to employees like you by employers, often as a part of a compensation package or performance incentive program. The benefits can be significant, but to best leverage ISOs to enhance your financial plan, you’ll need to understand the subtleties. Here are the top six advantages of this stock opportunity.
1. ISOs are simple to exercise.
One of the biggest benefits of ISOs is how simple they are to exercise. It’s a relatively straightforward process that you can approach in different ways depending on your short- and long-term financial goals.
Simply put, once your options are Here are three common ways to exercise ISOs:
- Upfront: With this option, you can pay cash to purchase shares upfront. For example, if you were granted 5,000 options at an exercise price of $20 per share and 1,000 shares have vested since you received your option grant, you can purchase those shares for $20,000 in cash. (1000 x $20 = $20,000.) This gives you the opportunity to take advantage of certain tax benefits, but it can also come with some risks. Your investment is subject to fluctuations in stock price, and this approach could reduce your ability to maintain a diversified portfolio.
Note: The next two options are typically only available to employees of public companies, whose shares are traded on the open markets.
- Cashless exercise: Also called a “sell-to-cover,” this option allows you to immediately sell some of your exercised shares, and then use the profits to pay for the options cost and any potential taxes. You would then keep the remainder of the profit.
- Same-day sale: The third approach is to sell all your shares immediately.
Each of these options offer relatively straightforward processes, and which method you choose depends entirely on you and your investment goals. Some employer plans even offer an early exercise option that allows you to exercise before your shares are vested, so make sure to check your plan document for details.
2. You control when to exercise.
One of the biggest advantages of ISOs is flexibility. Once your ISOs have vested, you’re in charge of your timeline. Consider these factors when you’re weighing when to exercise:
- How much the shares have appreciated in value since they were awarded
- How confident you are that the company will continue to thrive
- Whether or not you need money in the short-term
- ISOs have an expiration date and you will lose the right to purchase vested shares that have not been exercised by the expiration date.
- If you leave your company with vested shares, you typically have 90 days to exercise the options, so you will want to confirm the amount of time you have and plan accordingly.
One important note: If your role in the company means you have advanced knowledge of significant business information, you could be considered an insider and, therefore, restricted to selling stock during a specific trading window.
3. ISOs aren’t subject to payroll taxes.
One of the standout ISO benefits is a more favorable tax treatment than any other type of employee stock purchase plan. In addition, income from ISOs isn’t subject to FICA or Medicare payroll taxes, which can present a great opportunity to maximize your profits.
There are two types of dispositions (ways to sell, transfer, or exchange) for ISOs, each with its own distinct benefits:
- Disqualifying disposition: If you sell the resulting shares less than two years from the grant date and less than one year from the time of exercise, the sale will be considered a disqualifying disposition. Disqualifying dispositions are treated as ordinary income, though you don’t have to pay any payroll taxes, which could potentially save you a significant amount of tax dollars.
- Qualifying disposition: If you keep the exercised shares for more than a year before selling, they are then considered a qualifying disposition. This can allow you to take advantage of the lower, long-term capital gains tax treatment.
4. You have the opportunity for long-term capital gains.
A qualifying disposition can significantly lower the tax burden on your ISOs’ sale income. That’s because long-term capital gains are typically a lower tax rate than ordinary income or short-term capital gains rates. Other compensation programs like non-qualified stock options are treated as ordinary income on your W-2 and can create a significant tax burden. In contrast, ISOs are a type of stock option that can leverage long-term capital gains tax rates and help you grow your wealth, making them an attractive addition to your financial big picture.
5. You may be eligible for an alternative minimum tax credit.
When you exercise your ISOs, you may be subject to the alternative minimum tax (AMT). AMT applies when you exercise your ISOs, hold on to them, and elect to sell them in a subsequent calendar year. The AMT is based on the difference between the exercise price and the stocks’ fair market value.
Fortunately, if you do pay alternative minimum tax as a result of exercising your ISOs, you may be able to take advantage of the AMT credit, which can be used to lower a future federal tax bill. This can result in considerable savings.
6. You can participate in the success of your company.
If you’ve received incentive stock options, you’re likely considered integral to your company’s success. ISOs can deepen those feelings of ownership, pride, and agency that come from knowing you’re a part of something bigger – and you can benefit from your own hard work, too. As the company’s stock price rises, the value of your options will rise along with it.
Final Thoughts on the Advantages of ISOs
Maximizing your incentive stock options is a straightforward process that can result in significant opportunities. There’s a lot to consider, but because you’re able to take control of how and when you exercise your options, ISOs can be a very powerful addition to your financial plan.
If you would like to work with a financial advisor to devise a financial plan that serves your needs, contact us today! At Wade Financial Advisory, we currently serve clients working for companies such as Tesla, Facebook, Nvidia, Applied Materials, Apple, Microsoft Corporation, Google, Intel, Cisco Systems, Hewlett Packard, Pure Storage, Zoom Video Communications, Amazon, Adobe Inc., Palo Alto Networks and many others. We would be pleased to serve you and your family, too.