The Difference in Taxation of Employee Stock Options

Incentive and Non-Qualified Options Are Taxed Differently

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There are two types of employee stock options, non-qualified stock options (NQs) and incentive stock options (ISOs). Each is taxed quite differently. Both are covered below.

Taxation of Non-Qualified Stock Options

When you exercise non-qualified stock options, the difference between the market price of the stock and the grant or exercise price (called the spread) is counted as ordinary earned income, even if you exercise your options and continue to hold the stock.

Earned income is subject to payroll taxes (Social Security and Medicare), as well as regular income taxes at your applicable tax rate.

You pay two types of payroll taxes:

  • OASDI or Social Security, which is 6.2% on earnings up to the Social Security maximum taxable amount, which is $137,700 in 2020 and $142,800 in 2021
  • HI or Medicare, which is 1.45% on all earned income, even amounts that exceed the SS taxable amount

If your earned income for the year already exceeds your benefit base, then your payroll taxes on gain from exercising your non-qualified stock options will be just the 1.45% attributable to Medicare.

If your year-to-date earned income is not already in excess of the benefit base than when you exercise non-qualified stock options, you will pay a total of 7.65% on gain amounts up until your earned income reaches the benefit base than 1.45% on earnings over the benefit base.

You should not exercise employee stock options strictly based on tax decisions. That being said, keep in mind that if you exercise non-qualified stock options in a year where you have no other earned income, you will pay more payroll taxes than you’ll pay if you exercise them in a year where you do have other sources of earned income and already exceed the benefit base.

In addition to the payroll taxes, all income from the spread is subject to ordinary income taxes. If you hold the stock after exercise, and additional gains beyond the spread are achieved, the additional gains are taxed as a capital gain (or as a capital loss if the stock went down).

Taxation of Incentive Stock Options

Unlike non-qualified stock options, gain on incentive stock options is not subject to payroll taxes. However it is, of course, subject to tax, and it is a preference item for the AMT (alternative minimum tax) calculation.

When you exercise an incentive stock option there are a few different tax possibilities:

You exercise the incentive stock options and sell the stock within the same calendar year: In this case, you pay tax on the difference between the market price at sale and the grant price at your ordinary income tax rate.

You exercise the incentive stock options but hold the stock: In this situation the difference between the grant price and the market price then becomes an AMT preference item, so exercising incentive stock options might mean you’ll pay AMT (alternative minimum tax). You can get a credit for excess AMT tax paid, but it may take many years to use up this credit. If you hold the shares for one year from your exercise date (two years from the grant date of the option) then the difference between grant price and market price when you sell the options is taxed as long-term gain rather than ordinary income, and if your ordinary tax rate exceeds your AMT tax rate you may get to use some of the previously accumulated AMT credit. For high-income earners, holding the stock for the required time period can mean paying tax on the gain at 15% versus 20%. However, there are risks to this strategy that must be carefully evaluated.

Tax rules can be complex. A good tax professional and/or financial planner can help you estimate the taxes, show you how much you'll have after all taxes are paid, and provide guidance on ways to time the exercise of your options to pay the least tax possible.