There’s no shortage of confusion about what to do with investments, accounts, and complicated assets like various stock options since tax reform went through in the last few weeks of 2017. This is especially true of tech company employees and other young professionals who don’t just want to know the right thing to do… they want to know the best thing.
With the changes to the tax laws, those with access to company stock need to understand how the new code impacts you if you choose to exercise options. Here’s what you need to understand about exercising the stock options you have — including 3 strategies for doing so in a tax-efficient manner.
The Best Tax-Advantaged Stock Options for Employees
Previously, incentive stock options, or ISOs, offered the best course for employees concerned about tax ramifications. Under the new tax laws, ISOs continue to offer the best tax advantage for you as compared to non-qualified stock options (NQSOs) or restricted stock options (RSUs).
If you choose to exercise or vest RSUs or NQSOs, the IRS will tax you at ordinary taxes based on the date of exercise or vesting. On the other hand, when you sell ISOs, you can enjoy favorable rates because this type of stock is taxed as a long-term capital gain (LTCG).
That assumes, of course, that you meet the holding requirements for your ISOs. You can only take advantage of the LTCG rate one year from the date of exercise and two years from the grant date of the stock.
And there’s one big caveat to take into account. The drawback to using ISOs as a way to lessen your tax burden is that it puts you at risk of incurring alternative minimum tax (or AMT) at the time you exercise.
What You Need to Know About the Original AMT
The alternative minimum tax was enacted in 1969 once the government realized a small group of wealthy citizens could avoid regular income tax. But over the decades since the AMT was put into place, more and more taxpayers were on the hook for paying the tax.
In the past, rules around the AMT were not linked to inflation — which caused the increase in the amount of people subjected to the tax. Prior to 2018 and the new tax laws we see today, single taxpayers with $112,000 in income and joint filers earning $154,000 would likely need to pay.
That would put most software engineers and other tech employees into this bracket. In turn, being forced to pay the alternative minimum tax essentially eliminated the benefit of selling ISOs and not getting hit with income tax when you exercise.
The Challenges of AMT Under the Former Tax Code, and How AMT Looks Different for 2018
In the past, tech employees could try to recoup the loss through the alternative minimum tax credit in the years after exercising their stock options. The best possible tax outcome would have been to pay the AMT and recoup 100% of that tax in future years through the credit.
That would leave you with LTCG treatment for your entire gain (which is your selling price, minus the strike price). That wasn’t always easy to do, however, which often led to another strategy: limit the exercise of ISOs to stay below the threshold for triggering AMT in any given year.
But with the new tax laws effective January 1, 2018, employees could both exercise more of their stock options before triggering this tax at all and it should be easier to recoup any losses due to AMT through the credit.
We’ll see increases to the AMT exemption as well as the phaseout amounts, and that permits more ISOs to be exercised before triggering AMT. It will also be easier to use your minimum tax credits in future years, especially if you currently have minimum tax credit carryovers from prior years because you’ll likely be able to use these credits faster.
Let’s look at some examples to help illustrate all this and see how much you could exercise before you would trigger alternative minimum tax:
If you filed single…
A single person with wages of $150,000 who takes the standard deduction can exercise up to $25,700 in bargain element before triggering AMT.
If you filed a joint return…
A taxpayer files a joint return with joint wages of $225,000. They can also claim a mortgage interest deduction of $20,000 as well as property tax and state income tax deductions of $10,000 (which is the limit under the new tax law).
This taxpayer can safely exercise up to $40,470 in bargain element before triggering AMT.
If you file jointly but don’t exercise your ISOs in 2018…
Let’s say the same taxpayer from the example above files exactly the same — but does not exercise any ISOs in 2018. This taxpayer has $20,000 in AMT minimum tax credits from prior years.
The taxpayer will also receive a credit against their 2018 tax of $5,323, even if they don’t sell any shares of previously exercised ISOs. If the taxpayer also sells all of the ISO shares they previously exercised, the minimum tax credit against their 2018 tax will be $20,000.
The 3 Strategies to Follow for Exercising ISOs Under the New Tax Laws
The changes to the tax laws are still very new, and we won’t see the full effects until taxpayers start filing for their 2018 taxes in early 2019. But based on what we do know today, we can suggest a few strategies to follow if you want to pave the most tax-efficient path forward for you and your potential wealth.
Here are 3 strategies to deploy when exercising your ISOs in 2018:
Exercise and hold your ISO shares
The purpose of this strategy is to ensure you meet the LTCG holding period. There are situations in which you may want to exercise only enough of your ISOs to tiptoe up to the threshold of triggering AMT without going over. But it’s often more beneficial to exercise all your vested ISOs and pay some AMT if necessary because you can recoup the AMT in succeeding years through the minimum tax credit.
You’ll incur a smaller amount of AMT now than you would if you exercised later, after the stock price appreciates. This also allows you to start the holding period for LTCG sooner.
Hold some, sell some
Exercise and hold is a great strategy, particularly if the stock price appreciates. It is also possible to take a combined approach of exercising all then selling some immediately and holding the rest.
Selling immediately is referred to as a same-day sale. This works if you think the stock price has peaked and you want to diversify your portfolio or need the cash for other reasons. This strategy also offers you an opportunity to take some cash off the table and get LTCG rates on the balance you hold.
This alternative can also increase the amount of bargain element you can incur before triggering AMT on the shares you hold.
Sell in the same year you exercise
The risk in exercising ISOs, however, is that the stock value declines substantially after you exercise. You could still be on the hook for AMT, too; remember, it’s based on the stock value as of date of exercise, which would be higher than what you sold for.
The good news? There’s a strategy to mitigate this scenario, too.
If you sell your shares within the year you exercise your options, you will not be subjected to AMT. Instead, you’ll pay income tax at ordinary rates based on the difference between your strike price and the sale price. This is known as a disqualifying disposition.
The strategy to sell within the year you exercise requires that you be aware of any lock-out periods that would stop you from selling your shares when you planned to do so.
Here’s an example of how this particular strategy would work best:
Say a taxpayer exercises their ISOs in February 2018 with the stock value at $30 and a strike price of $10. The stock price falls to $15 by November, 2018.
Rather than paying AMT calculated at the $30 value, this person can sell the shares in November or December. In this case, the tax incurred will be based on the difference between the selling price and strike price at date of sale, which is $5 per share as per this example.
Regardless of which strategy you choose, you need to proceed with caution when exercising ISOs. You must have a strong understanding of how your actions impact your tax burden, and what the best options are around dealing with alternative minimum tax.
Failing to fully understand the ramifications of exercising, holding, or selling your ISOs can cost you a significant amount of potential wealth that gets lost to an inefficient tax strategy.
Don’t let this happen to you: if you’re unsure of the best course of action (or just want a second set of eyes on the strategy you’re considering), reach out to a financial advisor with expertise in this area and experience working with tech company employees.