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). The type is important, because they're not taxed the same.

Key Takeaways

  • Non-qualified stock options are taxed whether you exercise your option or not.
  • Incentive stock options are taxed based on the alternative minimum tax rules.
  • It's often best not to exercise either option based on the amount you'll be taxed, but rather on how you'll be taxed.

Taxation of Non-Qualified Stock Options

The difference between the market price of the stock and the exercise price (called the "spread") is counted as earned income when you exercise NQ stock options. That is the case even if you exercise your options and hold the stock.

Earned income is subject to payroll taxes (Social Security and Medicare). It's also subject to regular income taxes at your tax rate.

You pay two types of payroll taxes. The OASDI portion goes to Social Security. It's 6.2% on earnings up to the taxable wage base limit. The wage base is $142,800 in 2021. HI (hospital insurance) or Medicare is 1.45% on all earned income.

Your payroll taxes on gains from exercising your NQ stock options will be 1.45% for Medicare only if and when your earned income for the year exceeds the wage base of $142,800.

The Social Security wage base is $142,800 for all workers as of 2021. You won't pay more than $8,853.60 in taxes for Social Security if you earn more than that amount, or 6.2% of $142,800. Medicare continues to be taxed regardless of income. It has no wage base.

You will pay a total of 7.65% on gains if your year-to-date earned income is less than the base when you exercise NQ stock options. Your payroll taxes will switch to 1.45% on earnings over the base once your earned income reaches the base.

You should not exercise employee stock options based only on tax factors. But you will pay payroll taxes on it if you've held a stock with options, and you decide to exercise when you have no other earned income. That might be one time when you decide to exercise based on taxes.

All income from the spread is subject to income tax in addition to the payroll taxes. The extra gains are taxed as a capital gain, or as a capital loss if the stock price went down, if you hold the stock after you exercise and achieve additional gains beyond the spread.

Taxation of Incentive Stock Options

Unlike NQ stock options, a gain on incentive stock options is not subject to payroll taxes, but it is subject to income tax. It's a preference item for the alternative minimum tax (AMT) calculation.

There can be two tax outcomes when you exercise an ISO.

Exercise and Sell in the Same Year

You'll pay tax on the difference between the market price at the time of sale and the exercise price when you exercise the ISO and sell the stock in the same calendar year. It's taxed at your ordinary income tax rate.

Gains made from investments that you hold for one year or less are taxed as ordinary income. You're taxed at the capital gains tax rate if you hold them for more than one year. These rates can be lower.

Exercise and Hold in the Same Year

The difference between the exercise price and the market price becomes an AMT preference item if you exercise the ISO but hold the stock. Exercising incentive stock options might mean you’ll have to pay the AMT.

You can get a credit for any excess AMT tax if you pay too much, but it can take many years to use up this credit. The difference between the exercise price and the market price when you sell is taxed as a long-term gain rather than as income if you hold the shares for one year from your exercise date, or for two years from the grant date of the option.

You may get to use some of your prior AMT credit if your tax rate exceeds your AMT tax rate. Holding the stock for the required period can mean paying capital gains tax at 15% rather than 20% on the amount of gain that places you over $496,600 if you're a high-income earner. But there are some risks to this strategy.

The Bottom Line

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