Death and taxes. Two guarantees in life, and two of the most unpopular topics of discussion for most people. The good news is, we aren’t writing today to talk about death, but rather the T-word that happens to come around every year at the same time. While it might not be the most entertaining topic to throw out at your next dinner party, it is something that you and your financial advisor should be discussing on a semi-annual, if not quarterly, basis. This is especially true if you are the recipient of incentive stock options granted by your employer.
When it comes to incentive stock options, you have some favorable tax treatment on your side. However, you have to consider the burden of alternative minimum tax. But let’s not get ahead of ourselves. Here’s a closer look at how incentive stock options are taxed and what those tax implications could mean for your overall financial plan.
How Are Your Incentive Stock Options Taxed?
Incentive stock options are unique in that you are not required to pay tax when you exercise them as long as you:
- hold the stock option for two years or more after it has been granted to you, and
- hold the stock for one year or more after you exercise those options before you sell.
You only must pay capital gains tax—which has a maximum rate of 20%—on the difference between the exercise price and the final sale price.
If you fail to meet the requirements of the holding period, you could be taxed at an ordinary income tax rate, which could increase your tax obligation by 20% or more. The most important thing to consider before exercising your incentive stock options is the alternative minimum tax obligation. This is many times the most overlooked aspect of any stock option or equity compensation planning strategy.
How Could Alternative Minimum Tax Affect You?
When you exercise your incentive stock options, you could inadvertently trigger additional taxation on yourself through something known as alternative minimum tax (AMT). Working with an advisory team comprised of a CPA or other tax professional coupled with a seasoned financial advisor can help you plan and prepare ahead of time for unforeseen occurrences such as AMT, as well as help you implement effective incentive stock option tax strategies.
According to the IRS, “Under the tax law, certain tax benefits can significantly reduce a taxpayer’s regular tax amount. The alternative minimum tax (AMT) applies to taxpayers with high economic income by setting a limit on those benefits. It helps to ensure that those taxpayers pay at least a minimum amount of tax.”
Nearly all top-level executives will need to consider the AMT at one time or another throughout their careers. To go about getting a general idea of where you fall regarding AMT, follow these steps:
- First, calculate your normal taxable income.
- Then, add back in any tax deductions or exclusions you took when determining your regular tax bill. These would include things such as the difference between the purchase price on the incentive stock options and the current market value of those shares. This is called adding preference items.
Once you have calculated your income with AMT in mind, you can expect to be subject to two tax rates depending on your income level. As of last tax season, if your income level is less than $187,800, you could be subject to a 20% tax rate. If your income fell above that threshold, you could be subject to a 28% tax rate.
If you believe you will be subject to AMT, you can take some solace in the fact that roughly more than 4 million households in the United States are also subject to it each year. In fact, as a top-level executive, if your financial advisor is not having this conversation with you, you should consider working with a wealth manager that takes a more proactive approach to equity compensation planning because it plays such an important role in financial planning for executives.
Now that you have a better understanding of how incentive stock options are treated from a tax perspective, you can use this information to make a more informed decision regarding your equity compensation. We advocate a team of advisors comprised of a tax professional, a financial advisor that specializes in equity compensation strategies, and a legal professional to help you make the most of your financial plan while minimizing as much risk as possible throughout the process.
K. Wade Carpenter, CFP®, AIF®, ChFC®, CLU®, is an innovative wealth manager serving corporate executives and entrepreneurs from coast to coast. Throughout his more than 25-year career, Wade’s focus on C-level clients has made him a top strategist for equity compensation planning. For more information on how Wade and the Carpenter Team can advise you on incentive stock options tax implications and strategies, reach out today for a complimentary consultation.
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