I am taking a closer look at how Incentive Stock Options (ISOs) work as part of my ongoing equity compensation series. The types of equity compensation we typically see are ISOs, Restricted Stock Units (RSUs) and Non-Qualified Stock Options (NQOs). In January, I gave an overview of these three equity compensation methods, and in my last post, I explained the nuances of (RSUs). Similar to RSUs, ISOs come with a specific set of rules, and your own personal financial landscape and goals will determine the best way for you to approach them. A big difference between RSUs and ISOs is that ISOs aren’t direct compensation — they are an opportunity to invest your own money in a company’s stock at a discount. 

Companies often use ISOs to encourage employees to remain long-term and, ultimately, help the stock price rise — a built-in motivator to work hard and contribute to the bottom line. For the greatest tax benefit, ISOs require a holding period of at least a year, and a combined vesting/holding period of at least two years.  

How do ISOs work?

With ISOs there are three key dates to keep in mind: 

• On the grant date, an employer grants a finite number of stock options at a set “strike price.” ISOs come with a vesting schedule that shows when the employee will have the ability to exercise the options and turn them into actual stock holdings. 
• Once the established vesting period has passed, an employee can choose their exercise date. Ideally, by this time, the stock’s price has risen considerably above the strike price and the employee can buy stock at a steep discount. To be clear, you do not have to exercise your options. It’s up to you. And if the price isn’t something you like, you can hold off. 
• Once the options are exercised, the employee has the freedom to choose a sale date. The stock can be sold immediately (and taxed as ordinary income) or the employee can wait the appropriate amount of time and sell at a long-term capital gains tax rate. I’ll dive into more tax implications below.

If ISOs are a part of your compensation plan, make sure to keep track of these dates so you are equipped to make the choices that are right for you when the time comes to exercise your options or sell your shares. Doing nothing could be a costly mistake!

Should I sell or hold my shares after I exercise them?

I’ll get more detailed about taxes in the next section, but if you sell immediately, your profit from the sale will be taxed at your ordinary income rate. If you wait long enough to sell and are taxed at the long-term capital gains rate, you could pay nearly 20% less in taxes depending on what tax bracket you are in. And in that time, the stock could have increased in price further. 

Another consideration for whether to sell or hold is how you think the stock will perform. If you suspect it will do poorly long term, you should consider selling sooner rather than later. But if you think it will do well, and you don’t have pressing short-term cash flow needs, it could pay to hold onto it. But remember, investment returns are not a guarantee, and a stock’s price could decrease in value.

Be sure to take your goals, your risk tolerance and your tax situation into consideration before making a decision.

What are ISO tax implications?

The short answer is that if you sell within a year of your exercise date (and within two years of your grant date), you will be taxed at your ordinary income tax rate for the difference between the grant price and the sale price. If you do not know what federal tax bracket you are in, dig out last year’s tax return and find your “taxable income”. Line that number up with income brackets to get your marginal tax rate.

If you’ve held your stock for at least a year and a day from your exercise date, and two years have passed since your grant date, you can sell and pay the long-term capital gains tax rate. 

Certain filers are subject to an Alternative Minimum Tax (AMT) on the sale, though there is a scenario where a tax credit can be realized in future years. Learn more about the implications of the AMT and what it could mean for you.

It could be wise to try to spread out the sale of your stock options into more than one tax year to decrease the tax burden of a hefty payout. In any case, it is important to be as aware and informed as possible about the taxation rules because they have a great impact on your tax bill. Working with your financial planner can help with establishing goals and creating a holistic plan based on how you want to live your life; a tax professional can help sort out these important tax details. We recommend both!

What happens to my ISOs if I leave the company?

If you’ve already exercised vested shares, you own those shares and will continue to own them if you leave your company. For vested shares that you have not exercised, you have 90 days to exercise them in order to maintain ISO status. It is possible to negotiate an extension, but that may change your ISO status. 

How important is diversification when it comes to ISOs?

Diversification of your portfolio is always important, and you do want to make sure that your portfolio is not too concentrated in one company’s stock. Your investment goals and risk tolerance are two important factors to consider with how you diversify, and a CERTIFIED FINANCIAL PLANNER™ professional can help you find the mix of investments that supports your financial goals.

Kelly Luethje, CFP®, is Founder of Willow Planning Group, LLC. She provides financial education and guidance to help you live life on your terms. Kelly can usually be found on a mountain or by a lake working virtually with clients across the country across the country.