Taxation of Non-Qualified Stock Options
The difference between the market price of the stock and the strike price (called the “spread”) is counted as earned income when you exercise NSO stock options (buy the stock at the strike price), 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. Your employer will withhold these taxes when you exercise your options. You pay two types of payroll taxes. One type goes to Social Security. It’s 6.2% on earnings up to the taxable wage base limit. The wage base is $147,000 in tax year 2022 and $160,200 in 2023. HI (hospital insurance) or Medicare is 1.45% on all earned income. Your payroll taxes on gains from exercising your NSO stock options will be 1.45% for Medicare only if and when your earned income exceeds the Social Security tax wage base for the given tax year. 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 non-qualified 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 if you’ve held a stock with options and 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 when you exercise your options. On top of that, if you hold the stock and the price goes up, any gain above the spread will be taxed as a capital gain.
Taxation of Incentive Stock Options
Unlike NSO stock options, a gain on incentive stock options is not subject to payroll taxes, but it is subject to income tax. It may be a preference item for the alternative minimum tax (AMT) calculation. That means it’s not included when you calculate your regular tax liability but it is included when you calculate your liability for the alternative minimum tax. There can be two tax outcomes when you exercise an ISO, depending on when you sell the stock.
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.
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 $445,850 if you’re a high-income earner. 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.
