What are the advantages of ISOs?

(If you’re new to Incentive Stock Options you might want to start here with the basics.)

ISOs, short for Incentive Stock Options, can be a fantastic opportunity, but they come with important decisions and potential risks, particularly regarding taxes and investment diversification. Understanding the basics, knowing the terms, and planning strategically are key to making the most of your incentive stock options. Always consider seeking advice from a financial advisor or a tax professional to navigate the complexities effectively.

Advantages to ISOs

Financial Upside: If your company’s stock price rises above your option strike price(s), you can buy the shares at a discount and potentially sell them for a profit.

Limited Downside: There’s no cost to you until you choose to exercise their options, and no obligation to exercise. You can choose to exercise your options only if it is the right choice for you at the time.

Tax Advantages: This gets a little technical, so bear with us. ISOs offer favorable tax treatment if you meet certain conditions. This is mostly in comparison to other options structures, where exercising the options is a taxable event.

Taxes are a crucial aspect of ISOs. While there’s no tax due when the options are granted or vested, the situation changes when you exercise the options. It is true that unlike Non Qualified Stock Options, exercising your ISOs does not automatically mean the difference between the strike price and market value (sometimes called the “bargain element”) will be taxed as income. That’s good news! This makes exercising the options more financially feasible for most employees. However, exercising ISOs can trigger the Alternative Minimum Tax (AMT), which is a parallel tax system designed to ensure that taxpayers with substantial income pay at least a minimum amount of tax. Calculating AMT can be complex, so it might be wise to consult a tax advisor.

But that’s not all! When you exercise options you are buying shares of stock. If you hold onto that stock for at least 1 year after you exercise and 2 years after the options were granted before you sell the stock, you would likely only pay long-term capital gains taxes on the profit. (This is a lower rate than ordinary income, so that’s a good thing.) Selling before then would mean higher tax rates.

Decisions Employees Need to Make

If, and When, to Exercise: You’ll have to decide whether to exercise your options as they vest or wait in hopes that the stock price will increase further.

If, and When, to Sell: If you do exercise that means you’re buying company stock. Congratulations! Remember, holding the stock after exercising can lead to preferential tax treatment but also increases risk if the stock price falls. Deciding if, when, and how to sell that stock is an important decision.

Financial Planning: Consider how owning company stock fits into your broader financial plan. It’s generally risky to have too much of your wealth tied up in one stock so you’ll need to consider how it fits alongside your other investments (401(k), IRA, brokerage accounts, etc).

ISO Practical Examples

Example 1: 100 of your options with a strike price of $10 have vested, and the company’s stock price has soared to $50 per share. You could exercise your options and buy the shares at $10 (you’ll have to pay $1,000 to do this but that’s a lot cheaper than if you bought them at the market price, that would cost $5,000). After you exercise your options you have 100 shares of stock and can hold them, betting the price will climb even higher, or sell some immediately for a profit. (Remember the tax implications of selling immediately versus holding for at least a year though).

Example 2: Your 100 options with a strike price of $10 have vested, but the stock price is currently $8 per share. Since it’s below your strike price, there’s no immediate benefit to exercising your options. If you spent $1,000 to exercise them you’d immediately own $800 worth of stock. You might wait and hope the stock’s price rebounds.