Say you're lucky enough to work at a newly public company that passes out stock options like candy. Congratulations. Or maybe you work at an old-fashioned profit-making enterprise that has awarded you stock options for superior performance on the job. Either way, you have to decide when to exercise your options.
Like most important things in life, the decision is a judgment call. By exercising now, you can potentially reduce your overall tax bill. But you will also have an immediate tax cost. Plus, you run the risk that the stock will dive while you are hanging on to it. Here's how to evaluate the pros and cons.
Gunning for Long-Term Capital Gains Treatment
By exercising your options sooner rather than later, you improve the chances that you'll qualify for long-term capital gains tax treatment when you finally sell your shares.
If your options are the nonqualified kind (NQSOs), exercising and holding the shares over a year means all your post-exercise appreciation would qualify for the 15% or 20% long-term capital gains rate -- or even 0% if your 2013 taxable income (including the gains) is under $72,500 ($36,250 for singles). (For the more-than-one-year rule, start counting on the day after you receive the shares and count the day you sell.) In contrast, when you sell after a shorter ownership period, post-exercise gains are taxed at your ordinary rate, which could be as high as 39.6%.
If you have incentive stock options (ISOs), the rules are stricter. To get long-term capital gains treatment, you must sell the shares more than two years after the option grant date and have owned them over a year (starting with the day after the exercise date). If you pass the test, your entire profit -- the difference between the sale and exercise prices -- is taxed at no more than 15% or 20%. Yes!
So you can clearly see the tax advantage of exercising right now if you think the shares will go up and you expect to hold on long enough to take your profits in the form of long-term capital gains.
The Other Side of the Coin
Unfortunately, exercising right now is not a no-brainer.
First, you need money. If you borrow it, you'll owe interest. If you use your own, you'll give up what you would otherwise have earned on that money.
Second, bad tax things can happen on the exercise date. With an NQSO, the spread (difference between exercise price and market price on the date of exercise) is taxed as salary. That means you get taxed at your regular rate, plus you owe those ever-popular Social Security and Medicare taxes, too (1.45% or 2.35% or 7.65%, depending on how much you've earned by the time you exercise). Of course, this is not a big deal if you can exercise when there is little or no spread. However, your option-vesting schedule may prevent you from doing so.
With an ISO, you won't owe any "regular" income tax or any Social Security or Medicare tax when you exercise. However, the spread is treated as income for alternative minimum tax (AMT) purposes. That could throw you into the AMT-paying mode. If so, you'll join an increasingly large class of unhappy taxpayers. Granted, you will probably generate an "AMT credit" that you can use in later years to lower your regular tax. But that's small comfort. Again, this concern is mitigated if you can exercise when there is little or no spread.
Third, other bad tax things can happen after the exercise date. What if the stock actually declines? In the case of NQSO shares, selling for less than the market price at the time you exercised means a capital loss. Sorry about that. If you have other capital gains for the year, you can at least cut your tax bill by taking the loss against your profits. If not, you can write off up to $3,000 against your salary ($1,500 if you are married and file separately). Any excess loss won't help your tax situation until future years.
For the complete story, see Taxes on Stock Options
Waiting Until the Last Minute
Given all the potential negative outcomes of an early option exercise, I advocate the last-minute strategy. This is when the stock has risen to the point where you are ready to unload or just before the option expiration date, whichever comes first. Now you can exercise without any qualms. The tax cost, though, will be higher (possibly much higher). However, the additional taxes could be wholly or partially offset by earnings reaped from the money you didn't spend on exercising early. For an example of how this might work with an ISO, see Avoiding the AMT When Exercising an ISO. The same basic principles apply with NQSOs.
Of course, you could follow this advice and see your company's stock appreciate 300% over the next two years. Then you'll blame me for all the extra taxes. Go ahead, but remember this: Lottery winners have to pay taxes at regular rates, too, so don't expect any sympathy from your neighbors.