By Ian Hoffman, CFP®
If you’re like most executives we work with, stock options are a key part of your compensation. But do you know when to exercise stock options? Depending on how you time it, you could find yourself facing a hefty tax bill.
Here’s a closer look at some key things to consider before you exercise stock options.
Stock Options: Understanding ISOs vs. NQSOs
If you’re thinking about when to exercise stock options, keep in mind the distinction between two common types of executive compensation: incentive stock options (ISOs) and non-qualified stock options (NQSOs).
Incentive Stock Options
ISOs are often awarded for specific performance metrics. They generally have superior tax advantages to NQSOs:
- You don’t owe taxes when options are granted.
- You don’t owe taxes at the time of exercise.
- If you hold shares for at least two years from the grant and one year from exercise, the gain is taxed at the long-term capital gains rate (up to 20%).
- If you sell before these deadlines, the difference between the exercise price and fair market value is taxed as income.
Gains above the fair market value at exercise are taxed as short- or long-term capital gains, depending on how long you held the shares before selling.
Non-Qualified Stock Options
NQSOs offer greater flexibility than ISOs, but their tax treatment is generally less favorable:
- No taxes are due at grant (as long as options are at fair market value).
- At exercise, the spread is immediately taxed as income.
- Employers must withhold income taxes.
Just like with ISOs, gains above fair market value are taxed as short- or long-term capital gains at the time of sale.
Expiration Risk and the Cost of Waiting
It’s not uncommon for executives to put off exercising stock options. Many believe that waiting preserves upside, but the opposite can also be true. If you’re waiting for stock values to rise before you exercise, there’s a very real chance that the value could decrease in the meantime.
Exercise and Sell the Same Day
Many executives are tempted to hold on to company stock after they exercise stock options. However, this can lead to major concentration risk in your portfolio. We typically suggest treating stock options as compensation, not as an investment. When you exercise options and sell your stock, you can create diversified, more stable wealth.
We’ve found that for many executives, the easiest way to commit to diversification is to exercise stock options and sell on the same day. This can help prevent decision fatigue and reduce your risk of not following through.
Income Timing and Tax Year Management
Before you decide when to exercise stock options, it’s a good idea to weigh your potential choices carefully. However, contrary to what many people think, deciding whether to exercise stock options isn’t always the most important decision; deciding which tax year to exercise in is often more impactful.
We frequently advise clients to consider spreading large option exercises out over multiple years. Why? Exercising too many stock options at once can lead to a significant income boost. As an executive, you may also be juggling several other income events like:
- Bonuses
- Restricted stock unit (RSU) vesting
- Deferred compensation distributions
Consider paying attention to how exercising stock options might fit into your broader compensation picture.
Not Sure When to Exercise Stock Options?
Learning about stock option exercise timing is a good start. However, each executive has a unique financial picture, which is why individualized guidance on when to exercise stock options might help.
Since 2013, Thrive Wealth Management, LLC has supported clients in their goals of building stronger financial futures. With our unique iThrive Life Planning Process™, our team can assist you in creating your financial vision and taking meaningful steps toward it.
If you think we may be the right firm for you, contact us today. To schedule a meeting, call (215) 376-5530 or email ian@thrivewealth.com.
Frequently Asked Questions About Stock Options
What does it mean to exercise stock options?
To exercise stock options means purchasing company shares at the predetermined strike price specified in your option agreement. Executives typically exercise stock options once the market price is higher than the strike price, allowing them to potentially capture the difference as profit. However, the timing of when you exercise stock options can significantly affect taxes, diversification, and overall financial planning.
When is the best time to exercise stock options?
The optimal time to exercise stock options depends on several factors, including the type of options you hold (ISOs or NQSOs), your current income, the company’s stock performance, and upcoming tax considerations. Many executives consider spreading exercises across multiple tax years to manage income spikes and reduce the likelihood of moving into higher tax brackets.
Should I sell my shares immediately after I exercise stock options?
In many cases, exercising and selling shares on the same day can help reduce concentration risk, since executives often already have significant exposure to their company through compensation and benefits. If you’re looking for a financial partner to help you evaluate whether holding or selling shares aligns better with your broader financial strategy and long-term goals, the financial advisors at Thrive Wealth Management are here to support you.
About Ian
Ian Hoffman, CFP®, is a Relationship Manager at Thrive Wealth Management, LLC, a boutique financial planning firm in Blue Bell, Pennsylvania, where he works closely with advisors to keep clients on track with their long-term financial goals. Ian is known for his clear, straightforward guidance and works to build strong, holistic relationships with clients, while helping them navigate complex financial matters with confidence. Thrive prides itself on its independent, fiduciary approach and its focus on truly understanding client needs. Ian consistently strives to explain financial concepts clearly, in an effort to help clients stay grounded, especially during times of market volatility. His goal is to relieve clients of financial worries so they can focus on what matters most to them.
Ian began his career in 2015 at The Vanguard Group, supporting both retail investors and nonprofit corporations. In his current role, he’s committed to helping clients feel confident and prepared, with a focus on maintaining trust and being thoroughly prepared for every meeting. Ian earned his Bachelor of Science in Psychology from the University of Pittsburgh and holds the CERTIFIED FINANCIAL PLANNER® designation. Outside of work, he enjoys cycling, trying new restaurants in Philadelphia, traveling the world, and spending time with his wife and their son, Luca. To learn more about Ian, connect with him on LinkedIn.
Disclosure:
This material is provided for informational and educational purposes only, should not be viewed as an exhaustive discussion of the topics presented, and should not be construed as individualized advice for any reader’s personal circumstances. For guidance on how these matters may impact your financial plan or investment portfolio, please contact your Thrive Wealth Management, LLC representative. While the information presented is believed to be factual and up to date, Thrive Wealth Management, LLC does not guarantee its accuracy and, due to various factors, including but not limited to changing laws and regulations, this information is subject to change. All expressions of opinion reflect the judgment of the authors as of the date of publication. Thrive Wealth Management, LLC is not a law firm or an accounting firm, and no content contained herein should be construed as legal or accounting advice. Please consult with the qualified professional(s) of your choosing for legal and accounting advice.
Please visit https://thrivewealth.com/disclosure for additional information regarding the professional designations and credentials discussed. Professional designations and credentials do not guarantee success or any particular investment or financial outcome.
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