An incentive stock option (ISO) is an employee benefit that allows the right to buy shares of company stock at a discounted price. Also known as statutory or qualified options. Unlike other stock options, ISOs are not taxed when granted, upon vesting or when exercised. Another unique advantage is that these employees are generally taxed at the capital gains tax rate instead of the higher ordinary income rate.
ISOs are generally offered only to executives and top employees that the company would like to retain in the long-term. The thought is that these employees will help contribute to the growth and development of the company’s stock price.
The grant date is when your company issues your incentive stock options. Your ISOs are then subject to a vesting schedule. Once your ISOs vest, you have the right (but not the obligation) to purchase a certain number of company shares at the strike price. The options are given a strike price that is chosen by the employer company at time of issuance. Usually, this price is around what the company’s stock price is at the current time.
The ideal scenario to exercise is when the strike price is BELOW the market price. If the strike price exceeds the current market price, it does not make sense to exercise your ISOs since the company’s shares would be cheaper on the stock market. If the strike price never goes below the market price, your ISOs could expire worthless.
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ISOs are not taxed when granted, upon vesting or when exercised. This is a big advantage compared to other stock options offered. Taxes are deferred until shares are sold. However, keep in mind that holding ISOs past the same tax year in which you exercise them can potentially trigger the alternative minimum tax (AMT). Proper planning can help minimize this risk.
Holding period risk. Waiting to satisfy the “qualifying disposition” requirements makes sense from the tax perspective. However, the stock could fall during this time and negate the value of your stock option.
Departure from employer. If you separate from your employer but have vested ISOs, keep in mind that typically you have three months to exercise your ISOs to maintain their ISO status. After this time, your ISOs convert into NSOs.
Using a Certified Financial Planner (CFP®) can make understanding your ISOs a much more pleasant experience. Financial Planners can meet with your company’s HR department to better understand the ISOs that have been granted to you. A CFP will help determine the optimal time to exercise your ISOs in terms of the company’s stock price and taking into consideration your specific tax strategy.
If you have additional federal benefit questions, contact our team of CERTIFIED FINANCIAL PLANNER™ (CFP®), Chartered Federal Employee Benefits Consultants (ChFEBC℠), and Accredited Investment Fiduciary (AIF®). At PlanWell, we focus on retirement planning for federal employees. We serve as a financial advisor for federal employees with over 30 years of experience. Learn more about our process designed for the career federal employee.
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