When should I exercise my Incentive Stock Options or ISOs? This is one of the most common questions I hear from my clients as a financial planner that specializes in working with tech professionals at pre-IPO tech companies. The simple answer is that you should exercise your ISOs in January or as early in the calendar year as possible if you want to minimize taxes and minimize the risk of exercising and holding your ISOs. This answer assumes that your company is publicly traded.
Having said that, the more complex but better answer for when to exercise your ISOs depends on factors including your financial goals, your concentration in ISOs, and how much you want to save in taxes. This post will help you understand when to exercise your ISOs by giving you a framework for making that decision by addressing the issues below.
Table of Contents
- 1 What are ISOs?
- 2 How concentrated are you with your ISOs?
- 3 How do taxes work with your ISOs?
- 4 What are ways to save on your taxes with your ISOs?
- 5 When to exercise your ISOs?
What are ISOs?
ISOs are options that after you have vested them, give you the right to buy shares, but do not require you to buy those shares.
ISOs get much more favorable tax treatment compared to other types of employee equity including Nonqualified Stock Options (NSOs) and Restricted Stock Units (RSUs). Typically, when you start to work at a pre-IPO company, you are granted a specific number of ISOs with a specific exercise price. These ISOs also have a specific vesting schedule in which your vest or earn ownership of your ISOs over time.
A typical vesting schedule would let you vest 25% of your ISOs after your first year working at the company and a portion of the remaining 75% would vest each month over the next three years meaning you vest the entire grant, or 100% of your ISOs, after four years at your company.
Once you vest your ISOs, you own those ISOs. This gives you the right to exercise vested ISOs by paying the exercise price which means that when you exercise your ISOs, you buy the shares.
For example, let’s say when you start working at your pre-IPO company, you are granted 10,000 ISOs with an exercise price of $1.00 that will vest over 4 years with 25% vesting after 1 year, and then the remaining 75% vest monthly over the next 3 years. After 1 year at your company, you vest 25% or 2,500 ISOs. You have the option or right to exercise those ISOs, but you don’t have to. If you choose to exercise those ISOs, you will pay the exercise price of $1.00 per ISO or a total of $2,500, and now you own 2,500 shares in your company.
Now here’s the exciting potential of options.
Let’s say that your company had its IPO six months after you started working there and the stock price is $100 per share. The 2,500 shares that you could pay $2,500 for are worth $250,000 in the stock market! This is the happy path. Alternatively, let’s say your company had its IPO six months ago, but is struggling with the current stock price at $0.50 per share. You still have the option to pay $2,500 for shares that are worth $1,250. In this case, you likely wouldn’t exercise that option and buy those shares.
This leads to the next question to ask yourself.
How concentrated are you with your ISOs?
The first question I ask my clients and that you should ask yourself is how concentrated are you in your company stock with your ISOs? Said differently, how much are your ISOs worth and what percent does that represent of your total investable assets?
The reason your concentration matters is that if you’re highly concentrated in your company stock, you likely want to prioritize reducing your concentration above minimizing taxes because you’re taking on a ton more risk and volatility than when you hold a broadly diversified portfolio.
For example, if you are 95% concentrated in your company stock with your ISOs, you likely want to prioritize reducing your concentration vs. if you’re 5% concentrated in your company stock with your ISOs, in which case you may want to prioritize minimizing taxes.
My general guideline is that if you have more than a 20% concentration in your company stock with your employee equity, including your ISOs, then you are highly concentrated and should prioritize reducing your concentration over minimizing taxes because you’re taking on too much risk.
The risk with concentration is best illustrated by Enron which was a company that both Wall Street analysts and the public loved for years – until the year 2000. The stock price shot up for years to as high as $90 per share until bad news about company fraud came out and the stock fell to pennies within months.
Many Enron employees were highly concentrated in Enron stock. This was in part because their 401ks could be invested in Enron stock and the 401k company match was also made in company stock. Those employees that were highly concentrated in Enron stock lost hundreds of thousands of dollars in some cases, almost all of their retirement savings.
This shows you the true risk of being too highly concentrated in your company stock with your ISOs
How do you calculate your ISOs concentration?
The way to calculate your concentration with your ISOs is to follow the steps below.
Step 1. Add up the value of your ISOs and other employee equity including NSOs and RSUs.
Step 2. Add up the value of your other investable assets including investments, stocks, bonds, mutual funds, 401ks, and other retirement accounts. Add the value of your other investable assets to the value of your vested employee equity and this give you your total investable assets.
Step 3. Divide the value of your vested ISOs and other employee equity by your total investable assets, which gives you your concentration percentage.
Here are more details on how to calculate your concentration. In general, if your concentration is >20%, you are highly concentrated and should prioritize reducing your concentration in your vested ISOs.
How do taxes work with your ISOs?
Now that you understand how concentrated you are in your ISOs, you need to understand the tax treatment of ISOs.
When you exercise your ISOs, you pay $0 in ordinary income tax which makes ISOs different from other types of employee equity including NSOs and RSUs. This different tax treatment is why ISOs are often seen as the most valuable type of employee equity.
For example, when you exercise NSOs, you have to pay ordinary income tax on the difference between the exercise price and the fair market value.
What is the Alternative Minimum Tax (AMT)?
However, you may have to pay Alternative Minimum Tax (AMT) when you exercise your ISOs.
AMT is a parallel tax calculation that you or your tax professional calculates every year in addition to your ordinary income tax calculation. You pay the calculation that ends up higher which typically is your ordinary income tax.
AMT treats different types of income differently which leads to different taxes. Specifically, AMT treats the difference between your exercise price and the fair market value of your ISOs when you exercise as income for AMT purposes vs. this counting as $0 in income for ordinary income tax purposes. This means that in years that you exercise lots of ISOs, you likely will end up paying AMT on that ISO income.
Another important part of AMT is that you only have to pay AMT when you exercise ISOs in one calendar year and hold those same ISOs into the next calendar year. If you exercise ISOs in one calendar year and sell those same ISOs in the same calendar year, you don’t have to pay AMT; however, you do have to pay ordinary income tax.
For example, let’s go back to our case in which you exercise 2,500 ISOs and pay $2,500 in exercise cost for shares worth $250,000.
You have to pay $0 in ordinary income tax for this exercise; however, the difference in the $2,500 exercise cost and $250,000 in fair market value of $247,500 counts as ISO income for AMT purposes.
You should get help from a tax professional to calculate how much AMT you will owe. Having said that, if you pay AMT in a given tax year, you get an AMT credit for the taxes paid which you can use in future years to pay the difference in taxes when your ordinary income is higher than your AMT. You can use your AMT credit over a lifetime until it is used up.
What is the key tax benefit of your ISOs?
The reason you may be willing to pay AMT is to get the key tax benefit of ISOs. If you exercise and hold your ISOs for >1 year and >2 years after your grant date, these ISOs qualify for the lower long-term capital gains tax rate on the difference between your exercise price and the fair market value – this is the key tax benefit of ISOs.
This means you can get significant tax savings by not paying the ordinary income tax rate.
Specifically, 37% is the current highest Federal ordinary income tax rate while 20% is the current highest Federal long-term capital gains tax rate.
At the highest rates, you could save up to 17% in taxes on your gain if your ISOs qualify for the lower long-term capital gains tax rate. For instance, if you have $1,000,000 in ISOs gains that qualify for long-term capital gains, you could save $170,000 in taxes!
Let’s go back to our example in which you exercise 2,500 ISOs and pay $2,500 in exercise cost for shares worth $250,000. Let’s assume that you exercise and hold your shares from your ISOs for >1 year and >2 years after your grant date. Then let’s assume you sell your shares from your ISOs for $250,000. Your gain is $247,500 which is the difference between your exercise price and the fair market value. Since your gain qualifies for long-term capital gains, you could save up to ~$42,000 in taxes compared to if you had paid the ordinary income tax rate on the same gain! This example illustrates the key tax benefit of ISOs.
The key takeaway for you is that if you own ISOs, you have a huge opportunity to save on taxes.
What are ways to save on your taxes with your ISOs?
There are different ways to save on your taxes with your ISOs, but deciding which ones makes sense depends on your specific situation. You should talk with your tax professional or financial planner to make these decisions. Having said that, below are tax strategies that can typically save you on taxes.
AMT Crossover Strategy
One strategy I use with my clients who want to minimize AMT is called the AMT crossover strategy.
We ask a tax professional to do AMT tax projections to understand how many ISOs a client can exercise and hold until just before AMT kicks in, which is also called the AMT crossover point. Then the client will exercise and hold enough ISOs to get to the AMT crossover point which enables them to start the clock on qualifying those ISOs for the lower long-term capital gains tax rate, but pay $0 in AMT.
This enables a client to minimize AMT and exercise some of their ISOs over time.
Exercise Early in the Year Strategy
This is the strategy mentioned at the beginning of this post. This strategy helps clients who want to minimize taxes and minimize the risk of exercising and holding ISOs. This strategy also assumes that your company’s shares are publicly traded on the stock market.
To execute this strategy, the client will exercise and hold ISOs in the beginning of the calendar year. At the end of the calendar year, if the stock price is the same or higher, the client will hold the ISOs into the next tax year which means they have to pay AMT. After they have held the ISOs more than one year and the ISOs qualify for long-term capital gains, they sell the shares at the lower long-term capital gains tax rate which could save them up to 17% in Federal taxes on the gains.
If at the end of the calendar year, the stock price has dropped significantly, the client can sell the stock, pay ordinary income tax on the gains, and not pay AMT because the ISOs weren’t held into the next calendar year. This strategy enables clients to minimize the time they need to hold the ISOs before qualifying for long-term capital gains tax treatment.
For example, a client could exercise ISOs on January 2nd of this year and hold them until December 31st of this year. If the stock price is the same or higher, the client could hold ISOs until January 3rd of the next year and the ISOs would qualify for long-term capital gains treatment (assumes that ISOs are also >2 years after grant date). The client could sell on January 3rd and pay the lower long-term capital gains tax rate. The client only had to hold the ISOs for three days which minimizes the amount of time the client had to take the risk of the price dropping. Alternatively, if the stock price drops significantly by December 31st, the client could sell the ISOs, pay ordinary income tax on the gain, and pay $0 in AMT because the ISOs weren’t held into the next tax year.
Exercise and Hold for Long-Term Capital Gains
This strategy helps clients who want to minimize taxes by qualifying for long-term capital gains. The key risk is that the stock price will drop in the one year or more that the client needs to hold the ISOs to qualify for the lower long-term capital gains tax rate. This decision needs to be considered in the context of your financial goals, concentration, risk tolerance, and tax goals. In general, the less dependent you are on your ISOs to reach your financial goals, the greater risk you can take. The higher your concentration, the less risk you can take. The higher your risk tolerance, the more risk you can take. The more important saving taxes is to you, the more risk you can take.
When to exercise your ISOs?
This post has helped you understand what ISOs are, how concentrated you are with your ISOs, how taxes work with ISOs, what is AMT, what the key tax benefit of ISOs is, and possible tax strategies to save on taxes with ISOs. This should give you a framework for deciding on when to exercise your ISOs. You can make this decision on your own if you enjoy this type of work, or you can get help from a financial planner who specializes in helping tech professionals make the most of their ISOs.
If you have questions about your specific situation or want to chat with an experienced financial planner to help you so you can make the most of your ISOs, please schedule a free virtual consultation.