A stock option is the opportunity to buy or sell a stock at a predetermined price within a specified time frame. Employee stock options are given to certain employees by corporations as part of pay packages or as bonuses. The theory is that allowing employees to benefit when the stock goes up gives them incentive to make sure the stock does well.
Exercising your options is the process by which you buy the specified number of shares at the predetermined price. The timing of this is up to you, as long as it's within the time frame set out in your agreement. You're under no obligation to ever exercise your options; they will merely expire if they're not exercised by the deadline.
Taxes on Nonqualified Stock Options
When you exercise nonqualified stock options (NQSOs), the difference between the market price of the shares on that date and the exercise price, which is typically lower than the market price, is taxed as ordinary income. This spread is considered part of your wages, so it's also subject to FICA and Medicare taxes.
If NQSOs are held for more than a year before you sell them, the proceeds will be taxed at the long-term capital gains rate of 15 percent. If your income is below a certain level, including the gains ($67,900 if you were married and filed jointly in 2009), the earnings aren't taxed. If you sell them within a year, the short-term rate, which is your ordinary income rate, applies.
Taxes on Incentive Stock Options
There's no tax on incentive stock options (ISOs) when they're exercised. If you hold these options for more than a year after they're exercised and more than two years after the grant date, any earnings are treated as long-term capital gains and taxed at the 15 percent rate. However, exercising ISOs can trigger the alternative minimum tax (AMT) if they're not sold in the same year. The AMT is an additional tax levied by the U.S. Internal Revenue Service (IRS), meant to ensure that wealthier Americans don't escape tax liability through tax breaks.
Exercise and Sell
You will need to have enough cash to purchase your options, unless you exercise and sell them on the same day--which is appropriate if you think the share price of the stock has peaked, but this will have tax consequences. To mitigate the tax issue, you can exercise all your options but sell only enough to give you the cash you need.
Exercise and Hold
Exercising your options and holding them for more than a year gives you tax advantages, but it requires cash upfront and you can lose money if the stock price goes down. This is a good option if you have the cash on hand, believe the share price will go up and you won't need the money from your shares for at least a year.
Staggered Exercise Dates
If your options are ISOs and you're concerned about triggering the AMT, staggering your exercise dates over several years can help avoid that. The IRS has an online calculator to help determine if you might be affected by the AMT (see Resource).