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On Portfolio Planning Rande Spiegelman CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research May 25, 2004 If you have employer stock options, or if you’ll receive options in the future, you need to understand how they work. Making the right decisions about stock options can put money in your pocket. Making the wrong decisions could cost you money—in some cases, a lot of money. A stock option grant gives you the right, but not the obligation, to buy a certain number of shares of your employer’s stock at a set price within a certain timeframe. Conditions that apply to your options are spelled out in your grant agreement. It will tell you:
The tax treatment of incentive stock options and non-qualified stock options is different. Generally, ISOs are eligible for special tax treatment and NQSOs aren't. To qualify for special tax treatment, you must hold shares from an ISO exercise for longer than:
If you don’t meet the holding requirements, you’ll disqualify your ISOs and you will owe regular income tax in the year of the disqualifying disposition (the year you sell). The tax owed will be based on the lesser of the spread (difference between the strike price and the market price of the shares) at the time of exercise or disposition. For example, if the strike price is $10 and the market price is $40 at the time of exercise, the spread is $30. If you exercise 100 shares and later disqualify when the market price is $30, you would owe regular income tax on only $2,000 ($20 x 100). If you disqualify when the market price is $50, then you would owe ordinary income tax on the original exercise spread of $3,000 ($30 x 100) and the remaining $10 per share would be treated as short-term or long-term capital gain, depending on how long you’ve held the stock after exercise. A disqualifying disposition below the original market value at the time of exercise would generate a capital loss with no ordinary income. If you have more than $100,000 in ISOs vesting in one year (based on the market value at the time of grant), the amount over $100,000 is not eligible for special tax treatment. Exercising ISOs also may trigger alternative minimum tax (AMT). Although the ISO spread at the time of exercise is not taxable for ordinary purposes, it is included on your income tax return as an AMT adjustment. If AMT applies, you may owe additional income tax in the year of exercise. A disqualifying disposition in the same year of exercise eliminates the AMT issue, but if a disqualifying disposition occurs in a year subsequent to exercise you could be faced with the worst of both worlds—AMT in the year of exercise and ordinary income tax in the year of the disqualifying disposition. You should think of any AMT you might owe as a “prepaid” tax. Generally, if you hold the ISO stock for the required period of time in a qualifying disposition the sale may generate an AMT credit. The important thing to remember is you have a dual cost basis—the strike price at the time of exercise is your cost basis for ordinary tax (capital gain) purposes and the market price at the time of exercise is your cost basis for AMT purposes. Your tax preparer can figure out the rest, as long as you keep good records. The special tax treatment and holding periods don't apply to NQSOs. When you exercise NQSOs, you'll owe regular income tax in the year of exercise based on the spread at the time you exercise your options. NQSOs are also subject to income and payroll (FICA) tax withholding at the time of exercise. Exercising methods When you exercise options, you buy shares of company stock at the strike price. If the strike price is lower than the market price of the stock, the options are in the money. If the strike price is higher than the market price, the options are out of the money, or under water. As long as you can buy the company shares on a public stock exchange, you don’t want to exercise options that are under water since you’d pay more for exercising your options than you’d have to pay for buying shares on the open market. Generally, you can choose from three exercise methods (check your specific stock option plan):
A Schwab Equity Compensation Consultation is a good place to start. Before you exercise employer stock options, talk to a tax advisor or financial advisor. You need to understand how the exercise will affect your tax liability, and you may have to pay estimated taxes to avoid underpayment penalties for the year. The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment or tax advice. Each investor needs to review a security transaction for his or her own particular situation. Data contained here is obtained from what are considered reliable sources; however, its accuracy, completeness or reliability cannot be guaranteed. (0504-9621) Return to Top |
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