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 ISOs 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.
Key Definitions
- Grant date = when your company issues your ISOs
- Strike price = price to buy options set by employer company
- Exercise date = employee’s right to buy the options
- Vesting schedules = the % of ownership the employee has after a specified waiting period
- Unique to each company
- Graded vesting = the employee becomes vested in 1/5th of the options granted each year (fully vested after 6 years)
- Clawback provisions = conditions that allow the employer to recall the options for special circumstances (employee fired) or if the company is unable to meet its obligations due to financial reasons
How do ISOs work?
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.
When to exercise?
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.
Example:
- Company grants 1,000 shares of ISOs on 12-1-2022
- May exercise the options after 12-1-2024
- Employee can sell the options immediately after exercise on 12-1-2024 or wait 1 year for preferable capital gains treatment
- Taxable profit is the difference between the strike price and the price at sale
Key Rules:
- Employee must exercise their options with 10 years of receiving them
- ISOs can often be purchased at a price below the current market price, which results in an immediate profit
- Must be held for more than one year from the date of the exercise and two years from the time of the grant to qualify for more favorable tax treatment
- The shares must be held for more than one year from the date of exercise and two years from the time of the grant. Both conditions must be met for the profits to count as capital gains rather than earned income.
Tax Considerations:
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.
Risks:
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.
How To Get Help With Your ISOs
Using a Certified Financial Planner 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.
Reach Out to Us!
If you have additional federal benefit questions, contact our team of CERTIFIED FINANCIAL PLANNER™ (CFP®) and Chartered Federal Employee Benefits Consultants (ChFEBC℠). At PlanWell, we focus on retirement planning for federal employees. Learn more about our process designed for the career federal employee.
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