There is still time this year to make smart decisions with your company stock or stock options. Let’s look at the 2 most common types, RSUs and ISOs:
RSUs (Restricted Stock Units)
RSUs are simply shares company stock issued to employees upon vesting. Think of these as cash bonuses that your company turns around and buys stock with. They are taxed when they vest (unless pre-IPO) as ordinary income, i.e. just like wages. If the shares are sold for a gain within a year of vesting, the gain will also be taxed just like wages. But if you sell for a gain after one year, the gain will be taxed at capital gains tax rates, which are typically much less than ordinary income tax rates.
In most cases, I recommend selling your RSUs as soon as they vest (and if applicable, when the blackout period ends), so that the proceeds can be invested in something that aligns with your goals such as diversified low-cost index funds, high-yield savings, or even a stable money market fund.
If you’ve been holding on to your RSU shares and they have gone up in value, then the decision to hold or sell is case-by-case. It normally makes sense to sell the long-term holdings but in some cases you’re better off waiting until the next year and/or selling slowly over time.
ISOs (Incentive Stock Options)
ISOs have a vesting schedule just like RSUs, but instead of simply receiving shares of stock, employees have the option to buy (exercise) company stock at prices that are typically much less than the current value.
Let’s look at the following example:
Shares granted: 10,000
Grant Price: $3.00 per share
Shares vested: 2,500
Fair Market Value (FMV) for a publicly traded company is simply its current price. For a pre-IPO company, FMV is based on the valuation at the last round of funding and is sometimes called the 409a price.
Let’s say you are considering exercising your 2500 vested shares, and the FMV per share is now $8.00. Your options, in addition to doing nothing, are:
Cashless exercise: Buying for $3 and selling for $8 in a combined transaction, netting you $5/share, or $12,500. The entire $12,500 gain would be taxed as ordinary wage income. Some taxes would be deducted from the proceeds but oftentimes not enough, resulting in taxes being due at your next filing.
Buy and hold: Buy for $3/share ($7500) with the intention of holding for a year or more. The gain is just “on paper” for the time being and is unlikely to trigger a separate tax called AMT, discussed in a bit. If the FMV is still $8/share when you sell in a year, the $12,500 gain would be taxed as long-term gains which are much less.
Let’s look at the same decision, except the FMV is now $20/share:
Cashless Exercise: you would net $42,000 ((20-3)*2500) but that’s before ordinary income taxes are factored in.
Buy and Hold: you buy for the same $7500 as before. However, due to the higher FMV, the “paper gain” is now $42,000 instead of $12,500, so you would be subject to what’s called AMT (alternative minimum tax) at your next tax filing, even though you haven’t sold the shares yet! If you hold the shares for a year and then sell, you will still pay capital gains taxes but you will also (slowly) get the AMT credited back over several years. So essentially you are double-taxed at the moment you sell (AMT when you buy and capital gains tax when you sell).
How can AMT be avoided when exercising ISOs?
AMT is triggered if the “spread” or “paper gain” on an ISO exercise is too high relative to your other income. A good rule of thumb is that if the ISO spread exceeds 20% of your other income, it could trigger AMT.
For example, let’s say a single tax filer expects to have income of $180k in 2023. In the first example, the spread of $12,500 is only 7% of $200k so AMT is highly unlikely. But in the second example, $42,000 is over 23% of $180k so AMT is likely.
Every situation is different, but here are some basic strategies:
- Spreading out the exercise over 2 calendar years, i.e. some in December and some in January. That way, the gain will still exist but not be enough to trigger AMT
- Buying your shares while the FMV is still low, so that the spread is low. This has the added advantage of “starting the clock” on getting long-term gain tax treatment if you sell in a year.
- If you’re at a pre-IPO company that offers early exercise of ISOs, buy your shares right away and file an 83b election to lock in the “spread” at 0.
- Exercise as much as you can in years that will have higher than usual income. AMT is really the difference between regular income taxes and AMT-calculated taxes, so if you’re already in one of the highest tax brackets, AMT is less likely to happen.
All of this assumes that you are bullish on your company stock of course!