Exercising stock options is a big decision. It involves risk, cash, taxes—and timing.
Unlike RSUs (restricted stock units), which vest automatically and show up in your account, stock options require you to actively choose when to exercise.
And that means you’re putting money on the line. So the natural question is: should you exercise stock options now – or wait?
Let’s walk through the basics, the scenarios, and how to make a smart call based on your situation.
Step One: Are Your Options Underwater?
If your options are underwater—meaning the exercise price is higher than the current fair market value of the company stock—then it’s an easy answer:
Do not exercise.
Exercising would cost you more than simply buying the stock outright on the open market. There’s no upside, and it’s not worth the risk to exercise stockl options. Set those aside for now.
Step Two: What Kind of Stock Options Do You Have?
If your options are in the money (the stock is worth more than the exercise price), then the type of stock option you have matters.
There are two types:
- NSOs – Non-qualified stock options
- ISOs – Incentive stock options
Each comes with its own tax treatment and strategy.
If You Have NSOs (Non-Qualified Stock Options)
Your next step is to look at something called the bargain element – the difference between what the shares are worth and what it costs to exercise them.
When the bargain element is small:
This could be a good time to exercise stock options and hold the shares. Since NSOs are taxed as ordinary income at the time of exercise (based on the bargain element), a smaller gap means a lower tax hit.
We often see this with consultants who receive stock options as compensation. When their options have a low bargain element, exercising and holding can make sense.
When the bargain element is large:
A larger bargain element means a bigger tax bill. Since NSOs are taxed when exercised, you’ll owe tax immediately—even if you don’t sell the shares.
In that case, the better move is often to exercise and sell at the same time. This allows you to cover the tax from the proceeds and avoid tying up cash.
Also keep in mind: NSOs come with mandatory tax withholding, so you’ll pay some tax up front whether you like it or not.
If You Have ISOs (Incentive Stock Options)
ISOs have more favorable tax treatment, but they also come with added complexity—especially around the alternative minimum tax (AMT).
When the bargain element is small:
This is the best-case scenario. If you exercise and hold early enough, and the bargain element is small, there’s a chance you can avoid triggering the AMT. That means you start the clock for long-term capital gains without owing tax at exercise.
This is often the most tax-efficient approach with ISOs—if the timing and numbers work out.
When the bargain element is large:
You can still consider to exercise stock options and hold, but you’ll need to plan carefully around the AMT. The month you exercise matters.
- Exercising early in the year gives you time and flexibility to plan for the AMT bill.
- Exercising late in the year gives you little runway to manage that tax, and you may end up owing a large amount in just a few months.
It’s also worth noting that exercising and selling ISOs is not off the table. If the stock price is strong and you’d rather not take on the risk of holding, exercising and selling can still be a smart financial decision—even if it means giving up some of the tax advantages.
Final Thoughts: What to Consider Before You Exercise Stock Options
To decide what’s right for you, start by answering:
- Are my options in the money?
- Are they NSOs or ISOs?
- What’s the size of the bargain element?
- Can I afford the cost and the taxes?
- Do I want to hold the shares, or am I looking to sell?
The right move depends on your cash position, risk tolerance, and goals. There’s no one-size-fits-all answer, and what works for a colleague or friend may not be right for you.
Need Help Deciding?
This is a decision that benefits from context – and a plan.
At KB Financial Advisors, we work with tech professionals every day to make sense of their equity compensation and help them make smart, tax-aware moves.
Book a call with us if you want to talk through your stock option strategy.
You don’t have to figure this out alone.
Until next time!
