Written and reviewed by Brandon VanLandingham, CFA, CMT, CFP® · Last updated April 1, 2020
Equity compensation can be one of the most valuable — and most misunderstood — parts of a pay package. Options are not stock; they are the right to buy stock at a fixed price, and almost every decision you make about them has a tax consequence attached.
1. Know which kind of options you hold
Incentive stock options (ISOs) are granted only to employees and can qualify for long-term capital gains treatment if you hold the shares long enough after exercise. Non-qualified stock options (NQSOs) can be granted to employees, contractors, and directors, and the spread between your strike price and the share price is taxed as ordinary compensation income the day you exercise. Restricted stock units (RSUs) are different again: they are not options at all, and they are taxed as ordinary income as they vest, whether or not you sell.
2. Vesting and expiration set your calendar
Your grant agreement controls everything: when shares vest, when the option expires, and what happens if you leave, retire, or the company is acquired. Options that expire unexercised are worth nothing, no matter how far the stock has run. Two dates belong on your calendar every year — the next vesting date and the final expiration date of your oldest grant.
3. The alternative minimum tax is the ISO trap
Exercising an ISO and holding the shares creates no regular taxable income, but the bargain element is an adjustment for alternative minimum tax purposes. A large exercise in a single year can generate an AMT bill on paper gains you have not sold. Spreading exercises across multiple tax years, or exercising early when the spread is small, is often the difference between a manageable tax and a painful one.
4. Concentration is a risk, not a conviction
When your salary, your bonus, your benefits, and a large share of your investment portfolio all depend on one employer, a single bad quarter can hit your income and your net worth at the same time. There is no universal right answer for how much company stock to keep, but the number should be a decision you made deliberately rather than one that happened to you through years of vesting.
5. Coordinate the sale with the rest of your plan
Exercises and sales stack on top of your other income, so they influence your marginal bracket, capital gains rate, Medicare premiums, and the value of charitable deductions. If you plan to give, appreciated shares held more than a year are often a better gift than cash. If you are approaching retirement, the years between your last paycheck and the start of Social Security or required distributions are frequently the lowest-bracket years you will ever have — and a natural window to unwind a concentrated position.
A simple way to start
Pull your grant agreements together, list the type, strike price, vesting schedule, and expiration for each, and model the tax on exercising in one year versus several. That single exercise turns a pile of paperwork into a plan.
Equity compensation is highly specific to your grant documents and your tax situation. This article is educational and is not individual tax or investment advice.
Common questions
Should I exercise options as soon as they vest?
Sometimes. Exercising early can keep the taxable spread small, but it uses cash and takes on the risk of holding a single stock. The right answer depends on the spread today, your bracket, and how much company stock you already own.
What happens to my options if I leave the company?
Most plans give a short post-termination window — often 90 days — to exercise vested options before they are forfeited, and unvested grants are usually lost. Read the grant agreement before you resign or retire.
Do RSUs need a plan too?
Yes. RSUs are taxed as income at vesting whether or not you sell, and the default withholding is frequently too low for high earners, which produces a surprise at filing time.
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Frequently Asked Questions
- How are stock options taxed?
- Incentive stock options (ISOs) may offer favorable tax treatment but can trigger the Alternative Minimum Tax (AMT) upon exercise. Non-qualified stock options (NSOs) are typically taxed as ordinary income on the spread between the grant price and the fair market value at exercise.
- What is the difference between vesting and exercising stock options?
- Exercising options involves purchasing shares at a set price, while vesting refers to the process of earning the right to those options over time based on service or performance milestones. Many employees choose to exercise options once they have vested and the market price exceeds the strike price.
- What happens when stock options expire?
- The expiration date is the final day an individual can exercise their stock options; if not exercised by this date, the options typically become worthless. It is important to review grant agreements to understand specific deadlines, especially following a job change.
