Many American employees have many compensation packages in which stock options are one of them. It comes with complicated tax details even though all employees have the same right to purchase stock at a given price in a particular company.
That is why many taxpayers are better off getting help from a financial advisor to help them develop the right tax strategy for their investment.
Forms of Stock Options
The two significant forms of stock options are incentive stock options and nonqualified stock options. Even though these are not traditional compensation forms, they have their unique working principle.
It is typical for employees to get the nonqualified options as it allows you to buy your company's share at the grant price – the predetermined price in a given time frame. Should the stock value rise, one can sell it for gains.
Incentive stock options are like the nonqualified type even though they come with a special tax provision examined below, making employees prefer them. On the other hand, executives and other top-ranking officials do choose incentive stock options.
There is a vesting schedule that applies to both options in which you can purchase a particular amount of share every year for a definite year. No matter how long the vesting schedule is, one will be subjected to the grant price when getting the options. With this, if the company’s value soars, you will still buy your shares at the original price.
Taxes Affecting Nonqualified Stock Options
If you exercise your non qualified stocks, there will be a tax. For instance, you had a grant price of $25 per share, but you exercised your stock options, which shoot up its value to $35 per share. This is a profit of $10 for each share. With this, if you have 150 shares, your cost price will be $3750, while the value you will get will be $5,250. The $1500 profit will be classified as a compensation element. This will be reported to Uncle Sam like any typical income.
In time, you will desire to sell the stocks and make a profit from the sale. Your profit will be counted as a capital gain. If you sell the stocks within a year, it will be subjected to income tax (higher rate), while waiting for more than a year will have a lower rate – the long term capital gains.
Taxes that affect Incentive Stock Options (ISO)
On the other hand, incentive stock options do not have complicated tax rules for workers. Workers that get ISO as a compensation benefit will not be tax charged on the difference between the exercise time price and the grant price. It is not compulsory to report this as income when you exercise the option or receive the grant.
Taxes are, however, required from the funds from the proceeds of the sale of the real stock units. The lower tax rate of long term capital gains applies if the sales are two years following the grant and a year after exercising the option. If the sale is early, the higher income tax will apply.
It is essential to consider the AMT (Alternative Minimum Tax) as well. People that enjoy a series of income that are tax-free will be subjected to this and with this, make sure you have these rules in mind or get professional help.
When is the best time to Exercise Stock options?
Here are four good times when it makes sense to exercise a stock option:
Switching Jobs: if you are leaving a company, exercising your stock option is acceptable. Your boss will likely supply you with a post-termination exercise period of around three months for the process.
Exercise Early: Generally, there is the vesting of the option over a given period. Some employers can purchase company stock immediately if they accept the option grant. With an early exercise, you can be lucky to pay fewer taxes on profits.
Initial Public Offering: When the shares of a company go public, there is the option to exercise and sell the stock. However, do not forget that holding the tax for less than a year will lead to a higher tax rate.
Company Acquisition: A company that is acquired might convert or compensate their employee's stock options into the new company's shares. Exercising the stock might happen after or during the merging process.
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