Every December, the KB Advisors team is inevitably flooded with calls from people who are rushing to exercise incentive stock options (ISO) before December 31st. They want to make sure they exercise what they can in the current year without triggering the alternative minimum tax (AMT). This influx of calls is always exciting for me. It means that people are taking a proactive role in their finances.
Unfortunately, I’m always a little dismayed to find that the emails and calls about exercising ISOs stop on January 1st. What people don’t realize is that January can be an even better month to exercise their ISO for several reasons. Let’s dive into why you should consider exercising your ISO at the start of this year rather than waiting till next December.
If you exercise in January, you’re giving yourself the longest possible time between when you exercise and when any potential AMT is due. The difference between your exercise price and FMV (bargain element) is large, so you’re likely not going to completely sidestep the AMT.
However, If you exercise in January, you’re creating the potential for the AMT now – but it won’t be due until the following April. This gives you 14-15 months between when you exercise and when you pay the taxes. This timeframe is long enough for you to prepare sufficiently for your upcoming tax bill next filing season. Additionally, exercising in January offers you another tax-efficient strategy: the ability to qualify for long-term capital gains on your shares.
By the time your taxes are due, you’ll have satisfied the required holding period for long-term capital gains. That means you may be able to exercise now in January and then sell some shares in February or March of next year to be able to pay your AMT bill.
Please note: you need to get specific for your situation in order to avoid the underpayment penalty. An underpayment penalty goes into effect when you don’t make required estimated tax payments, or you pay some of it – but the amount you pay is significantly less than the estimated amount owed. Typically, underpayment is calculated using one of two figures:
- 90% of your owed taxes for the current tax year.
- 100% of your owed taxes based on last year’s tax return.
Luckily, if you’re exercising your ISO, you may qualify for a safe harbor provision to provide some protection. For most tech employees, you may be safe from the underpayment penalty because your salary is climbing year after year. This means that your withholdings may be equivalent to what you would have owed in taxes according to your last return, and they could meet the payment requirements for the IRS. However, you can’t take this for granted – make sure that you’re paying enough in taxes and are prepared for paying your AMT bill next filing season either through withholdings or targeted saving.
#2: Opportunity to sell in a Disqualifying Disposition
In a perfect world, you exercise in January. Over the next twelve months, the fair market value (FMV) will continue to go up. You sell after meeting the one-year holding period at a price that is much higher than the price you exercised in January. At this point, you qualify for long-term capital gains and can sell at this new, higher price to pay your AMT bill, and still have some cash flow remaining.
But the world isn’t always perfect – and the market doesn’t always act the exact way we’d like for it to. Your share price can do one of three things:
- Go up.
- Stay the same.
- Go down.
If you exercise, trigger the AMT, and the stock price goes down, the AMT bill doesn’t go away. Paying AMT on a share price that’s higher than the price you can now sell at is a terrible feeling. Luckily, there’s something you can do.
If the stock price goes down, you can sell the shares before December 31st in a disqualifying disposition. A disqualifying disposition, in this case, is when you exercise your ISO now and then later sell the shares in the same calendar year that you exercised.
Wait a minute – you might be saying – Why would I exercise in January if that gives my stock more time to potentially decrease in value?
Exercising in January gives you, in theory, 11 months to evaluate the share price and decide if a disqualifying disposition is the right move for you. When it comes to financial and tax planning, having time on your side is always optimal. If the share price falls after you exercise and you sell in the same year you exercised, the AMT bill that you would have owed goes away, and your taxes are based on the lower price at which you sold – not the higher price you exercised.
To take advantage of this strategy, you need to pay attention to your tax rates. The AMT rate is 28%. If you exercise in January and then sell in the same calendar year, your taxes will be based on the price that you sold. However, you’ll pay the tax at your ordinary income tax rate. This is the rate you pay on your salary. Make sure that you know what your ordinary income tax rate is – there might be a chance for you to calculate a break-even price if your ordinary income tax rate is higher than 28%. The ultimate goal is to make sure you’re saving as much as possible on your tax bill when possible. A little bit of pre-planning can go a long way.
#3: Trading Windows
If you’re exercising stock options, you want to be aware of your trading windows. A lot of what we’re going over here is based on the theory that you exercise your ISO in January and then can sell anytime you like.
If you exercise in January, you have 11 months (till December 31st) to evaluate the stock price and decide if you should sell in a disqualifying disposition. You have 14 months (till April 15 of the next year) to prepare for the AMT bill – possibly by selling after 12 months at a long-term capital gains rate.
However, trading windows may mean that the actual time within which you can make those moves is more restricted. If you’re restricted to exercising during a trading window, exercise on the first day of your first trading window. Don’t exercise on the last day of your trading window – we want to avoid a situation where you exercise on the last day of a trading window, then next year you satisfy the holding period for long-term capital gains outside of the trading window. Essentially, you want to set yourself up for future success when you decide to actually sell your shares.
This move guards you against a sudden market downturn, or a plummeting stock price, during a time when you’re not permitted to sell. It also protects you against a missed opportunity to sell to provide cash flow for your AMT bill because you didn’t meet the holding requirement during a trading window.
The best time to exercise ISO can be summed up in one word: Early.
Exercise early, and file an 83(b) if you have the opportunity.
If you can’t exercise in January, exercise early in the year, and as early as possible in your trading window. Incentive stock options offer the greatest opportunity to take advantage of good planning. You can save yourself thousands of dollars in taxes, and provide you and your family with more cash flow in the coming year.
Want help creating a strategy for exercising ISO? Let’s talk.