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Why The Beginning of The Year Is Prime Time For Exercising ISOs Thumbnail

Why The Beginning of The Year Is Prime Time For Exercising ISOs

Are you ready to exercise your Incentive Stock Options (ISOs)? 

Most employees believe the end of the year is the perfect time to exercise their options. Surprising to many, exercising in January can actually open up some more opportunities you may not have considered.

Why can exercising at the beginning of the year be so beneficial?

Tax Recap: How The IRS Taxes ISOs

With ISOs, you have two different tax systems to contend with:

  1. Federal Income and Capital Gains Tax
  2. Alternative Minimum Tax 

When you exercise your options (aka buy them), you have to count the "spread" (difference between fair market value and exercise price) toward your annual AMT calculation (even before you sell the shares). 

You will also have to pay ordinary income or capital gains tax when you sell your shares (depending on your holding period). Ideally, you structure your plan to limit the AMT to the extent possible and pay long-term capital gains tax on any profits you generate. 

We’re not going to get into the weeds with the tax implications of exercising ISOs. Jump back to our recent post for a refresher on ISO taxation.

1. Exercising In January Can Help You Pay Your AMT Bill

AMT is a secondary tax system for high-income earners intended to put a floor on taxes paid in a given year. If you exercise your ISOs in January 2022, you extend the timeline between when you exercise and when you actually have to pay the AMT tax bill. 

That bill would not be due until April of 2023. Fifteen months is a solid chunk of time to prepare, especially if you're anticipating a higher tax bill. 

On the other hand, exercising in December of 2021 would require you to pay your AMT tax bill by April 2022—and four months will come sooner than you think!

While this is an excellent strategy for those facing a significant AMT tax burden, you need to ensure you're withholding enough taxes throughout the year, so you aren't faced with an underpayment penalty

Depending on the level of AMT, you may need to make estimated quarterly payments or withhold more on your paycheck. Generally speaking, if your household income is greater than a defined threshold ($75,000 for single, $150,000 for MFJ), the IRS requires you to pay at least 90% of the tax for the current year or 110% of the tax shown on the return for the prior year (whichever is smaller) throughout the current tax year. For example, you may have only withheld 80% of your tax burden throughout the year because you failed to factor in the AMT burden.

Be sure to check with your tax professional to ensure you meet all IRS requirements.

2. You Start The Clock On The Holding Period To Qualify for Long-term Capital Gains

ISO taxes are even more complicated when it comes time to sell your company stock. If you plan to hold the stock for a more extended period, you must be aware of the requirements needed to achieve a “qualifying disposition.” 

If you hold the shares for over two years from the grant date and one year from the exercise date, your profits will be taxed at long-term capital gains rates (as opposed to the higher ordinary income rates).

When you exercise in January, you start the clock on that holding period. After 15 months (when the AMT is due), there is a good chance you would have satisfied the requirements for a qualifying disposition and could sell your shares to cover the AMT costs. Conversely, exercising in December doesn’t give you enough time to hold the stock and may force you to sell as a “disqualifying disposition” (which isn’t always bad, you just don’t have as much time to make your decision). 

3. You Can Make Strategic Decisions About Holding and Selling Your Shares

In an ideal world, you want to exercise your ISOs at a lower price and watch the fair market value of your shares continue to climb. As you know, it doesn’t always work out that way. 

By exercising in January, you have a full year to decide how to handle your share (i.e., sell, hold, a combo, etc.). If the stock price soars, perhaps you want to sell (even if it's disqualifying). 

The same could be true if the shares decline. While we can’t predict short-term market activity, it certainly doesn’t hurt to have more flexibility within your strategy.


Things To Watch-Out For When Exercising ISOs

It’s important to understand the factors that can quickly derail any plan you put together for your ISO exercise strategy. 

  1. Trading Windows: Many companies have a set schedule for when you can buy or sell their stock as an employee. These trading windows may or may not line up with your ISO strategy.
  2. Blackout Periods: Aside from the trading windows, your company may have specific blackout periods that restrict trading. A typical example of this would be before a company earnings announcement. This helps prevent insider trading and market manipulation.
  3. Market Risk: It’s easy to get tied up in the technical traits of ISOs and feel like you have an airtight strategy in place. Unfortunately, most profits generated from employee stock compensation are the result of uncontrollable market performance. With that in mind, the first step in your plan should be to identify your risk tolerance and risk capacity. How much fluctuation in the stock price can you withstand (personally and financially)?

At Rivermark Wealth, we help our clients make informed decisions on their ISO's by running multiple scenarios and talking them through the critical factors (i.e., tax mitigation, concentration risk, cash flow considerations, etc.).

Schedule an introductory phone call with us today and learn how to optimize your employee stock compensation for 2022 and beyond.