Amazing guacamole comes from knowhow. As any amateur dip maker can tell you, the key to great guacamole is great avocados. Picking the right avocados from the market is an art as much as a science. When it comes to your stock options understanding when your options will ripen forms the foundation for success down the line.
There are two main types of stock options: incentive stock options (ISOs) and non-qualified stock options (NSOs). Often, ISOs are offered mainly to top management and key employees, while NSOs are commonly available to all employees of a company as well as others such as contractors, vendors, and consultants.
Employees typically choose to exercise ISOs at a price below the fair market value of the company’s shares, and the discount they receive on these shares (the “bargain element”) is eligible for favorable tax treatment. NSOs, on the other hand, are considered wages, and the longer an employee waits, the more wages they get taxed on. However, by strategically ripening NSOs, you can limit the amount of tax liability those shares incur.
There are two elements to get the best guacamole avocados: there is the best time “pick” (buy) and “slice” (sell). But when to pick and slice depends on the type of avocado. Similarly, the type of stock option also makes a big difference when it comes to stock options strategy.
The tricky part about NSOs is that the difference between the strike price and the fair market value is included in wages; that means the more growth, the more is subject to a higher rate of taxation. Exercising an NSO while the difference is low means that less is included in wages, and so long as an employee has waited a minimum of one year, the growth from exercise date will be subject to long-term capital gains tax. The difference between wages and long-term capital gains can make a substantial difference in the amount of tax you owe. For example, in 2021, individuals with income between $40,401–445,850 and joint filers reporting $80,801–501,600 in income are taxed 15% on long-term capital gains but, according to federal income tax brackets, can be subject to 22–37% tax on wages.
Holders of ISOs have two elements of ripeness to keep in mind:
To get the most guacamole, it’s critical to tend to both timelines.
If your company allows employees to exercise their stock options early (before vesting), this can provide a couple of different benefits, depending on the type of options you have.
It’s important to note it isn’t enough just to early exercise. You must file an 83(b) election within 30 days of exercising stock options. Early exercise and 83(b) election don’t always result in tax savings or greater overall returns, however, so be sure to speak with a fiduciary investment advisor who is well versed in the tax consequences of stock options before making your decision.
When your company is headed for IPO, the financial decisions you make can have enormous influence over your financial future. WRP specializes in helping employees and executives in pre-IPO companies navigate this complex process. To learn more about how to make more guacamole from your company shares, browse our blog or our free resource library.