Understanding ISOs and How They Work
Equity compensation is becoming an increasingly popular way for companies to attract and retain talent. One form of equity compensation is stock options, which give employees the ability to purchase company stock at a predetermined price. However, being granted stock options doesn’t mean you actually own any stock yet—you must exercise them to convert them into shares and have the potential to profit.
Incentive Stock Options (ISOs) are a special type of stock option that comes with tax advantages. Here’s how they work from a tax perspective:
- When ISOs are granted, nothing happens from a tax standpoint.
- Over time, ISOs vest, meaning you gain the right to exercise them.
- Once vested, you have a window of time to exercise them before they expire.
- When you exercise ISOs, there is no immediate tax impact.
- When you sell the stock after exercising, the tax treatment depends on how long you’ve held the shares.
Common Mistakes to Avoid with ISOs
While ISOs can offer significant benefits, they also come with potential pitfalls that can cost you money if you’re not careful. Here are some of the biggest mistakes I see people make when managing their ISOs:
1. Triggering the Alternative Minimum Tax (AMT)
One of the biggest tax traps with ISOs is the Alternative Minimum Tax (AMT). AMT is triggered when there is a large difference between your exercise price (the price you pay for the stock) and the fair market value of the stock at the time of exercise. This “spread” can result in a large, unexpected tax bill at the end of the year—even if you haven’t sold the stock yet. If you’re considering exercising ISOs, work with a tax professional to estimate your potential AMT liability.
2. The Buy and Hold Risk
Exercising your ISOs and holding the stock for the long term may seem like a good strategy, especially if you believe in your company’s future. However, if the stock price drops significantly after you exercise, you could lose money. You paid cash to exercise your options, and if the stock price falls below your purchase price, you’re sitting on a loss. Evaluate the volatility of your company’s stock before exercising and consider diversifying instead of holding all your wealth in one stock.
3. Missing the 90-Day Window After Leaving Your Job
If you leave your company, you typically have only 90 days to exercise any vested ISOs before they expire. Many employees don’t realize this and end up losing their options simply because they didn’t take action in time. If your ISOs represent a significant portion of your compensation, plan ahead and consider whether it’s worth exercising them before you leave.
4. Exercising While Your Company Is Private Without a Liquidity Event
Some employees make the mistake of exercising ISOs while their company is still private, paying a large amount of money upfront but having no way to sell the shares. If the company remains private for years or never goes public, your money could be tied up indefinitely. Make sure you have enough cash reserves and a clear strategy before exercising in a private company.
5. Failing to Account for Expiration Dates
ISOs don’t last forever. If you don’t exercise them before they expire, you lose them. Some employees wait too long, either because they forget or because they’re waiting for the stock price to go higher, only to miss their opportunity completely. Be aware of your expiration dates and have a strategy in place for when to exercise.
6. Overconcentration in Your Company’s Stock
It’s easy to get excited about your company’s potential, but investing too much in your employer’s stock can be risky. If your company’s stock performs poorly or the company experiences financial trouble, you could lose a large portion of your wealth. A diversified portfolio can help protect you from overexposure to a single company’s performance1.
Final Thoughts
Managing ISOs requires careful planning to avoid unexpected taxes, losses, and missed opportunities. Understanding the tax implications, having a strategy for exercising and selling, and working with a financial professional can help you maximize the benefits of your ISOs while minimizing the risks.
If you’re unsure how to handle your ISOs, let’s set up a time to talk—I help clients navigate these decisions to ensure they align with their financial goals.
1 Diversification does not assure a profit or protect against market risk. There is no guarantee a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio.
Content in this material is for general information only and is not intended to provide specific tax or financial advice or recommendations for any individual. Clients should consult with their qualified tax and financial advisors as appropriate.
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