It feels good when you’ve got different stock options to work with to grow your wealth. What doesn’t feel good is when you don’t know when to sell stock options, or what moves to make based on their different types.
After all… taxes? (Some stock options are taxed differently than others.) Return on investment? (Some stock options are best sold immediately for the best ROI, while others are better off holding for a year.)
As you’ve progressed in your career, there are several different types of stock options that you may have accumulated. Knowing which is which, and what tax rules are associated with each stock option type, can be a huge help when determining what to sell and when.
Types of Stock Options To Look For
Incentive Stock Options (ISO)
Incentive Stock Options (or ISOs) are offered to employees as an incentive to stick around for the long-run. Many times they serve as part of your compensation package, or are offered instead of a traditional cash raise. ISOs don’t typically have traditional income tax when you exercise them but might trigger the alternative minimum tax (AMT).
Nonqualified Stock Options (NSO or NQ)
Nonqualified Stock Options (or NSOs/NQs) are also a way that employers can offer a benefit to employees. Typically, an employer will offer their employees the option to purchase a number of shares of their company’s stock at a predetermined price per share. The employee has to use this option within a specific time frame. If the employee doesn’t use their option within the given time frame, they lose the option altogether.
Restricted Stock Units (RSU)
A Restricted Stock Unit (or RSU) is a form of compensation that an employer often gives to high-level employee. However, they’re becoming increasingly popular in specific industries for all levels of employees – for example, tech industry professionals likely are compensated, in part, through RSUs. RSUs are given to employees through a vesting plan and distribution schedule – they have no tangible value until they’ve completed vesting.
Employee Stock Purchase Plan (ESPP)
An Employee Stock Purchase Plan (ESPP) is a larger program run by a company where participating employees are permitted to purchase stock shares at a discounted price. This plan is funded through payroll deductions from employees who are participating in the plan.
And…
You also may find that you have shares from past stock option exercise as part of your total stock option portfolio.
The Dilemma: When To Sell Stock Options?
Knowing what to sell and when to sell (or whether you should sell at all) can be a tough decision to make. You may find that your colleagues are all exercising their stock options, and you have an overwhelming sense of FOMO (Fear Of Missing Out). Alternatively, you might be suffering from analysis paralysis where you’re stuck feeling unsure about whether or not you should sell, or what the financial implications of exercising your stock options might be.
Regardless of how you’re feeling, it’s important to have a financial strategy in place for your stock options. Get clear on what you’re going to do now so that after the IPO, or during your next trading window, you’ll know exactly what to do (and why you’re doing it!).
Selling Stock Options and Taxes
A plan to sell stock options is, essentially, a tax plan. No matter which way you look at your stock options, selling them is going to involve paying taxes in one form or another. There are a few different types of taxes you might wind up paying:
- Regular Income Tax
Also referred to as ordinary income tax, this is the tax you pay on your salary. Some (though not all) stock options will be subject to regular income tax.
- Capital Gains Tax
This is the tax you typically pay on your investments. Capital gains tax can be long-term at a lower rate than regular income tax if you’ve held your investments for a year or more.
- Alternative Minimum Tax (AMT)
AMT is different than any other tax, and often more difficult to understand. Typically, AMT is triggered by Incentive Stock Options (ISOs), but it can also be triggered if you have a high income.
How Do You Prioritize Selling Based On Taxes?
The key to deciding if and when you should sell is to understand how taxes impact each of your employee stock options and build a strategy from there. Let’s take a look at a few examples of the most common stock options available:
Restricted Stock Units
RSUs are taxed at regular income tax rates when they vest. However, it’s important to keep in mind that RSUs may be subject to double-vesting if your company is going through an IPO. If you received your RSU in a pre-IPO company, your stock option may be dependent on if/when your company is acquired or goes through an IPO..
Priority #1: When developing your tax-focused stock option strategy, RSUs are the first you should consider selling.
Employee Stock Purchase Plan
There are no taxes when you purchase stock within an employee stock purchase plan, but taxes are incurred when you sell. It might be wise to contribute to your ESPP, then sell purchased shares ASAP to convert the discount into a small cash bonus.
Priority #2: ESPPs are the second stock option you should consider selling.
Nonqualified Stock Options
Non-qualified stock options work a little bit differently than ESPPs, but have a similar framework. Just like in your ESPP, you control the timing of your taxes with non-qualified stock options. You pay regular income tax on your bargain element when you choose to exercise your NQs, and you might need to pay capital gains tax if you hold the shares after exercising your options.
Typically, your best strategy is to wait until the stock in your nonqualified stock options reaches a price you like, or you need the cash more than you need the stock in your portfolio. Then, exercise and sell your options the same day to avoid capital gains tax.
Priority #3: NQs are the third stock option you should consider selling.
Incentive Stock Options
ISOs aren’t taxed at regular income tax rates when you exercise your options. However, you may run into possible AMT. The good thing is that you’re in control of the timing here. You’re only going to incur taxes if and when you exercise your options, which means you have a lot of planning opportunities with your ISOs that could potentially help you to navigate around the AMT. However, it’s good to keep in mind that the portion of income you receive from the exercise of your ISO that might be subject to AMT can be calculated using this simple formula:
Number of ISO Exercised x (Current FMV – Exercise Price) = The Bargain Element
ISOs offer a lot of big tax advantages that are key for tax planning, especially if, like many tech professionals, you’re a high-income earner.
Priority #4: ISOs are the fourth stock option you should consider selling.
Shares
Shares should be looked at in two different ways:
- Shares that are on a vesting schedule.
- Shares that you own outright, or that have already vested.
Shares that have a vesting schedule based on your company’s performance are usually triggered by an acquisition or an IPO. If this is the case, you should expect to sell them ASAP after they’re vested. There’s no tax advantage to holding shares from RSUs, or that are triggered after an IPO or acquisition. In fact, if you choose to hold on to them, you can expect a large tax bill in your near future. Even if you do sell quickly, it’s possible that the income tax withholdings on your RSU won’t be sufficient, and you’ll probably owe additional taxes when you file next season.
If your shares aren’t on a vesting schedule (say shares from a past exercise of options) that’s tied to company performance, they may be worth holding onto. You’re going to end up paying some capital gains tax depending on whether you’ve held them over the short or long-term.
A key thing to remember is to make sure your cost basis is correct when exercising your stock options. Double check the cost basis if the shares you’re selling are from the exercise of ISO, and you paid AMT on that exercise. This can help to protect you against double taxation – an all too common issue among taxable stock options.
Still unsure whether or not you should sell your shares? It’s tough, because shares are less clear-cut when it comes to tax planning. You’ll likely pay the lowest rates and the least taxes when selling shares, so it can be tempting to sell them first. However, there are several reasons to sell other options and equity ahead of your shares:
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- Your shares will never expire like your stock options will. They’re yours forever – so you might as well hold on to them.
- Exercising stock options usually triggers some type of tax event, but shares aren’t taxed until you sell. Your cost basis will likely be higher in any unexercised stock option than in long-term shares – so exercising and selling stock options first makes sense. This could mean you have a bigger opportunity for the stock price to fall and create a capital loss.
Priority #5: Shares are usually saved as the last thing you want to sell. There are times when extenuating circumstances warrant they be sold first – contact your financial planner if you have any questions about shares you’re holding.
Basic Guidelines to Keep In Mind
To put it simply, there’s a general framework that most people follow when selling stock options and equity:
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- RSU
- ESPP
- NQ
- ISO
- Shares
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Each person and plan is unique, which makes it tough to create a definitive rule for when and how you should exercise stock options, or sell them. Working with a financial planner to help you determine what strategy will be best for you is key to saving on taxes while still getting the income you deserve. And we’d be happy to help you. Click the button below to set up a consultation today.