What to Do with Stock Options: When to Exercise & Tax Planning Strategies

There are many potential paths to building wealth—whether it’s through long-term investments, selling a business or buying real estate. But for those who help a company grow, stock options offer a unique and rewarding route to financial success. While this path can be full of twists and turns, it can also be one of the most powerful ways to create lasting wealth.

Stock options are more than just a part of your equity compensation—they’re an opportunity to benefit from your company’s growth. But if you’re new to stock options, it’s easy to feel overwhelmed. Questions like, “When should I exercise stock options? And how do they fit into my overall financial plan?” can come to mind. That’s where equity compensation strategies and thoughtful planning for your stock options can help navigate this complex process.

Our wealth managers believe your financial journey should be empowering. Stock options, when approached thoughtfully, can play a key role in that journey. Whether you’re a tech professional, startup contributor or working in a high-growth industry, we believe in helping you confidently navigate the complexities of stock options—turning them into a strategic tool for long-term financial success.

What are stock options?

What are stock options and how do they work in your overall financial plan? Stock options give you the opportunity to share in your company’s success and growth. Stock options give you the right to buy company stock at a set price (called the strike price), usually set at the market price when awarded. If the company performs well going forward, you can buy the stock at that previously set price and sell it for a profit, benefiting from the stock price appreciation.

Why do companies offer stock options? Because they want to align your incentives with the company’s long-term success. As the company grows and thrives, stock options allow you to directly benefit from the company’s stock price performance.

Types of stock options: ISOs vs. NQSOs

Many clients ask us when is the optimal time to exercise stock options to minimize taxes and maximize gains. There are two main types of stock options you might encounter, each with its own set of rules and tax implications. Understanding the differences can help you make informed decisions about how and when to exercise your options to best fit your financial situation.

1. Incentive Stock Options (ISOs)
   These are usually reserved for employees and offer favorable tax treatment if you meet certain conditions. After you exercise ISOs, you might be able to qualify for long-term capital gains tax rates on subsequent growth, which are lower than ordinary income tax rates.
2. Non-Qualified Stock Options (NQSOs)
   NQSOs are more commonly offered to a wider group of employees, including contractors and board members. Unlike ISOs, when you exercise NQSOs, you’ll need to pay ordinary income tax on the difference between the strike price and the stock’s current market price.

So, whether you’re sitting on a stack of ISOs or NQSOs, knowing which type you have and how they’re taxed is step one on your journey to maximizing your stock options.

Stock option terms you should know

There are key stock option terms you need to know for successful financial planning. Let’s break down some key terms that will come up as you navigate your stock options:

• Strike Price: This is the price at which you can buy your company’s stock. It’s typically set when the options are granted and won’t change, even if the stock price soars.
• Vesting Period: The time you need to work at the company before your stock options are eligible to be exercised. Vesting can occur monthly, quarterly, or annually, and it often takes 1-4 years to fully vest.
• Expiration Date: The deadline by which you must exercise your options. This is usually 10 years from the grant date.
• Option Spread: This is the difference between your strike price and the current market value of the stock. For example, if your strike price is $10 and the stock is worth $100, your option spread is $90 per share—before taxes.

How stock options work

Picture this: You’re granted 10,000 stock options at a strike price of $10 per share. After a few years of hard work, your company goes public and now the stock is worth $100 per share. You’re excited, right? Here’s what happens next:

1. Vesting: Let’s say your options vest over four years. After four years, you can exercise all 10,000 options.
2. Exercising: You decide to exercise your options, meaning you buy the shares at the $10 strike price. You pay $100,000 to acquire 10,000 shares. At exercise, you will owe income tax on the $900,000 bargain element.
3. Selling: If you sell immediately, you pocket the proceeds after paying the income tax due (say, $450,000 or 50%).

But here’s the exciting part: If you believe in your company’s future, you might choose to hold onto those options. If the stock price rises to $300 per share, your $900,000 bargain element could grow to $2.9 million, thanks to the built-in leverage of stock options. This allows you to benefit from the company’s growth in a big way.

However, it’s important to remember that there’s risk involved. If the stock price drops below your strike price, your options could lose their value entirely. While stock options offer incredible potential for growth, they also expose you to significant volatility, so it’s important to weigh the risk and reward carefully.

When should you exercise your stock options?

Knowing when to exercise your stock options is one of the most important decisions you’ll make—and it’s not just about watching the stock price. The timing of your exercise can affect your taxes, your ability to meet your financial goals and exposure to market risk. It’s important to carefully consider your unique situation, including your company’s performance and your personal financial objectives.

Here are a few key questions to ask yourself before making your decision:

• What are your financial goals? Do you need liquidity now, or can you afford to hold your options for potential future growth? Exercising early might help you achieve goals like buying a house or paying off debt now. Waiting for the stock price to rise is exciting but it also involves risk, and there’s no guarantee of bigger gains. It’s always wise to discuss your options with a wealth manager to ensure your decision aligns with your overall financial plan and long-term goals.
• How’s your company doing? If you believe your company’s stock will continue to rise, holding off on exercising might be worth the wait. On the other hand, if the stock is already at a high and you’re unsure about the future, it might be time to cash in.
• What about taxes? Taxes play a huge role in this decision. NQSOs are taxed as ordinary income at the time of exercise, while ISOs could trigger alternative minimum tax (AMT), which we’ll cover in more detail later. Carefully planning your exercise date with tax strategies in mind can help reduce your tax liability.

Tax implications for stock options

Let’s look at how to manage tax implications for stock options and avoid costly mistakes. Navigating taxes with stock options can be tricky, but it’s essential to get it right if you want to maximize your wealth and minimize unnecessary costs. Whether you have ISOs or NQSOs, your tax strategy plays a huge role in how much you get to keep after you exercise and sell your options.

Taxes: Non-Qualified Stock Options (NQSOs)

When you exercise NQSOs, the difference between the strike price and the stock’s fair market value (FMV) at the time of exercise—called the “bargain element”—is as ordinary income. This income is subject to federal, state and payroll taxes (Social Security and Medicare), regardless of whether you sell the stock immediately or hold onto it.

For example:

• Strike Price: $10
• Stock Value at Exercise: $100
• Bargain Element: $90 per share

If you exercise 10,000 options, you’ll have $900,000 in taxable income, which is added to your regular salary for the year. The higher your income, the higher the tax bracket you’ll fall into, so timing your exercise is crucial.

NQSO tax strategy: Manage your tax bracket

If you’re already earning a high salary, exercising all your options at once might push you into a higher tax bracket. Instead, consider spreading out the exercise of your NQSOs over several years. This tax bracket management strategy can help keep your income in a lower bracket, minimizing the amount of taxes you owe in any given year.

For example:
Let’s say you have 10,000 NQSOs, and you’re already in a high tax bracket. By exercising and selling 2,500 options per year over four years, you can spread out the income and potentially avoid pushing yourself into the highest tax bracket all at once.

NQSO tax strategy: Year-end exercise vs. year-beginning

If you expect your income to be higher next year, consider exercising at the end of the current year to take advantage of your current, possibly lower tax bracket. If you anticipate lower income next year due to a planned job change or retirement, waiting until January could allow you to pay taxes at a reduced rate.

NQSO tax strategy: Cashless exercise

A cashless exercise is an option that allows you to exercise your stock options without having to put up the cash to buy the shares. Essentially, a portion of your shares is sold immediately to cover the cost of exercising and your taxes. This can be useful if you need to minimize the upfront cash outlay.

Taxes: Incentive Stock Options (ISOs)

ISOs are generally more favorable from a tax perspective, but they come with stricter rules. When you exercise ISOs, the bargain element is not taxed as ordinary income. Instead, the bargain element may be subject to Alternative Minimum Tax. Also, you’ll owe taxes when you sell the shares. If you meet the required holding periods, you may qualify for long-term capital gains tax on the appreciation after exercise, which is typically much lower than ordinary income tax.

ISO tax strategy: Holding period for ISOs:

• You must hold the stock for at least one year after exercising.
• You must also wait two years after the options were granted.

If you don’t meet both of these conditions and sell the shares early, you’ll trigger a disqualifying disposition, and the bargain element will be taxed as ordinary income, similar to NQSOs.

ISO tax strategy: Qualifying for long-term capital gains

Let’s say you exercise ISOs with a $10 strike price when the stock is worth $50. If you sell immediately, you’ll trigger a disqualifying disposition, and the $40 per share difference will be taxed as ordinary income. But if you hold the shares for more than one year and meet the two-year requirement, you’ll only pay long-term capital gains tax on the difference between the exercise price and the selling price.  Note that the $40 per share may be subject to the Alternative Minimum Tax under certain circumstances. See more about that below.

For example:

• Strike Price: $10
• Exercise Price: $50
• Sale Price After Holding for More than a Year: $100

The $90 per share gain would be taxed at long-term capital gains rates, which is typically 15-20%, versus ordinary income tax rates that could be as high as 37%.

ISO Tax Strategy: Managing Alternative Minimum Tax (AMT)

While ISOs offer the potential for long-term capital gains, they come with the risk of triggering the Alternative Minimum Tax (AMT). AMT is a parallel tax system designed to ensure that high-income earners pay a minimum amount of tax, regardless of deductions or exemptions.

The bargain element (the difference between the strike price and the market price at the time of exercise) is included in the AMT calculation for the year you exercise your ISOs, even though it’s not taxed as regular income. If your AMT liability is higher than your regular tax liability, you’ll have to pay the AMT for that year.

For example:
If you exercise ISOs with a $10 strike price and the stock is worth $100, the $90 per share bargain element is added to your AMT calculation. If you hold onto the shares and the stock price declines, you could end up paying AMT on a value that no longer exists.  Since the AMT tax is a parallel system, its possible to pay AMT and capital gain tax on a portion of the stock option exercise in different years.

To avoid a big AMT bill:

• Exercise in small batches over several years to minimize the bargain element in any given year.
• Work with your tax advisor to estimate your AMT liability before exercising.

ISO Tax Strategy: Sell Immediately to Avoid AMT

If you think AMT might apply and you don’t want to deal with it, one strategy is to exercise and sell your ISOs immediately (a same-day sale or disqualifying disposition). While this strategy means you’ll lose the opportunity for long-term capital gains, it also allows you to avoid AMT entirely since the bargain element is treated as ordinary income.

General stock option strategies

• Charitable donations to offset taxes: Donating appreciated stock to charity can help you avoid capital gains tax and take a deduction for the full market value. This is especially useful for those in high-income brackets. Consult your tax advisor to maximize the benefits.
• Exercise during a low-income year: Exercising stock options in a low-income year, such as during retirement or a sabbatical, can help reduce your tax liability.
• Cashless exercise options: A cashless exercise lets you sell part of your stock immediately to cover the cost and taxes, providing liquidity without needing upfront cash. However, this may limit future stock gains.
• Diversify to manage risk: To reduce the risk of over-concentration in one company’s stock, sell a portion of your options and reinvest in a diversified portfolio. This aligns with our philosophy of globally diversified, long-term investing.
• Preparing for an IPO or liquidity event: Plan for potential lock-up periods, market volatility, and tax implications when your company approaches an IPO or liquidity event.
• If you leave the company: After leaving your company, exercise vested options within the 90-day window to avoid losing them and consult a financial advisor for guidance.

Stock options and your financial plan

As wealth managers, we focus on how to integrate stock options into your financial plan for long-term wealth building. Your stock options should be integrated into your larger financial plan. Whether you choose to exercise early or hold out for bigger gains, the goal is to make sure your stock options help you achieve your long-term financial goals—whether that’s saving for retirement, buying your dream home or creating a legacy for future generations.

We’re here to help you make the most of your stock options. Ready to start the conversation? Reach out to one of our wealth managers today, and let’s create a plan that puts you in control of your financial future.

Related Resources

• Equity Compensation Guide
• Navigating Liquidity Events: Key Insights for IPOs, M&As and Buyouts
• 3 Strategies for Exercising Incentive Stock Options
• Restricted Stock Units (RSUs): What You Need to Know About Taxes, Selling Shares and Long-Term Strategies