Your stock option loses its option value the moment you exercise because you no longer have flexibility around when and if you should exercise. As a result many people wonder when does it make sense to exercise an option. Tax Rates Drive the Decision to Exercise The most important variables to consider when deciding when to exercise your stock option are taxes and the amount of money you are willing to put at risk.
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There are three kinds of taxes you should consider when you exercise your Incentive Stock Options the most common form of employee options : alternative minimum tax AMTmoment of option exercise income tax and the much lower long-term capital gains tax. You are likely to incur an AMT if you exercise your options after their fair market value has risen above your exercise price, but you do not sell them.
If you then hold your exercised options for at least one year before you sell them and two years after they were moment of option exercise then you will pay a combined federal-plus-state-marginal-long-term-capital-gains-tax-rate of only The AMT you paid will be credited against the taxes you owe when you sell your exercised stock.
If we assume the same outcome as in the example above, but you wait to exercise until the day you sell i.
Any future appreciation will be taxed at long-term capital gains rates if you hold your stock for more than one year post exercise and two years post date-of-grant before selling.
If you sell in less than one year then you will be taxed at ordinary income rates.
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The most important variables to consider in deciding when to exercise your stock option are taxes and the amount of money you are willing to put at risk. Most companies offer you the opportunity to exercise your stock options early i.
Exercising Options and Expiration - Macroption
If you decide to leave your company prior to being fully vested and you early-exercised all your options then your employer will buy back your unvested stock at your exercise price. The benefit to exercising your options early is that you start the clock on qualifying for long-term capital gains treatment earlier.
The Scenarios Where It Makes Sense to Exercise Early There are probably two scenarios where early exercise makes sense: Early in your tenure if you are a very early employee or Once you have a very high degree of confidence your company is going to be a big success and you have some savings you are willing to risk. Early Employee Scenario Very early employees are typically issued stock options with an exercise price of pennies per share.
It could make a ton of sense to exercise all your shares before your employer does its first A appraisal if you can truly afford to lose this much money.
Exercising Options and Expiration
I always encourage early employees who exercise their stock immediately to plan on losing all the money they invested. In many cases that might not be until you really believe your company is ready to go public. The Optimal Time to Exercise is When Your Company Files For an IPO Earlier in this post I explained that exercised shares qualify for the much lower long-term capital gains tax rate if they have been held for more than a year post-exercise and your options were granted more than two years prior to sale.
To find the ideal time to exercise we need to work backwards from when your shares are likely to be liquid and valued moment of option exercise what you will find to be a fair price. Employee shares are typically restricted from being sold for the first six months after a company has gone public.
What occurs when a security meets its strike price?
There is usually a period of three to four months from the time a company files its initial registration statement to go public with the SEC until its stock trades publicly. Therefore you will take the minimum liquidity risk i. These characteristics included meeting their pre-IPO earnings guidance on their first two earnings calls, consistent revenue growth and expanding margins. Based on these findings, you should only exercise early if you are highly confident your employer can meet all three requirements.
The higher your liquid net worth, the greater the timing risk you can take trend in internet earnings when to exercise. In that case you can better afford to lose some money, so exercising a little earlier once you are convinced your company is going to be highly successful without the benefit of an IPO registration may make sense.
Exercising earlier likely means a lower AMT because the current market value of your stock will be lower.
Option Exercise & Assignment
The difference between the AMT and long-term capital gains rates is not nearly as great as the difference between the long-term capital gains rate and the ordinary income tax rate. In contrast an average Wealthfront client typically pays a combined marginal state and federal ordinary income tax rate of In any case we strongly recommend you hire a great tax accountant who is experienced with stock option exercise strategies to help you think through your decision prior to an IPO.
Disclosure The information contained in the article is provided for general informational purposes, and should not be construed as investment advice.
This article is not intended as tax advice, and Wealthfront does not represent in any manner that the outcomes described herein will result in any particular tax consequence. Prospective investors should confer with their personal tax advisors regarding the tax consequences based on their particular circumstances.
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- An American option is a version of an options contract that allows holders to exercise the option rights at any time before and including the day of expiration.
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