Janice B: ‘Recently, I read that the tax consequences are different for the same options depending on whether they are exercised when they are “in the money” (what does that mean exactly?). For instance, suppose you have options at $10, exercise them (buy the shares), and then later they go to $20 and you sell. Is that different tax-wise from waiting until they go to $20, then exercising (buying at $10) and selling right away?’
☞ In the first place, ‘in the money’ means ‘worth something if exercised today.’ So if your employer’s stock is $8 and YOU have the privilege of buying it any time in the next 5 years at $10, well, that is a privilege . . . but not one you’d want to exercise today. Your options (in this example) are out of the money. When the stock gets to $12 (or even to $10.01) your options are ‘in the money.’ And when it gets to $20, they are very nicely in the money.
So what happens if you exercise your option? One of two things:
- Exercise and sell and you have a taxable short-term gain.
- Exercise and don’t sell, planning to wait a year and report a more lightly-taxed long-term gain, and you have the alternative minimum tax to worry about.
For AMT purposes, the excess of the fair market value of the stock over the exercise price is included in income immediately, even if you don’t sell and the stock you hold then collapses. That’s what happened to a horde of Silicon Valley “option millionaires” who exercised incentive stock options in early 2000, planning to hold the stock a year and a day to get long-term gains treatment. The value of their stock plunged, but their Alternative Minimum Tax bills remained huge. Not only did they not make a huge profit on their options, they lost a fortune because of the taxes.
So . . . two rules:
1. Only exercise options when they’re sufficiently “in the money” to make you a nice pot of money. Obviously, there’s rarely any point in exercising an out-of-the-money option. (Why exercise and buy at $10 when you could buy on the open market at $8 and preserve your option, to boot?) And generally, an only-slightly-in-the-money option shouldn’t be exercised either, at not least not until shortly before it expires, because the general trend of stock prices (speaking very broadly here) is up. If options have a long way to run, think twice about cashing them in, because you give up their remaining “time value.” (Having the option but not the obligation to do something for the next few years can be very valuable.) It certainly makes sense to cash in if the stock has gone nuts, as the dot-coms did. But if it’s stock in a company whose profits tend to grow, and whose stock price might grow along with profits, then the longer you wait, the deeper into the money might your options be when you exercise.
This is a very tough decision, and depends on: (a) how well you think the company will do; (b) how well you think its stock will do (if interest rates rise, even the stock of companies doing well may fall); and (c) your own personal circumstances. Two people with identical stock options could very rationally make different decisions if one were living hand-to-mouth (exercise! sell! pay off those credit card balances!) and the other had a $2 million inheritance and could afford to risk that the stock would go down instead of up.
(Because it’s such a tough decision, what most people naturally and sensibly do is hedge their bets, exercising a little bit at a time instead of all at once.)
2. Once you do exercise . . . SELL immediately and pay the taxes.
Quote of the Day
The subjects of every state ought to contribute towards the support of the government, as nearly as possible, in proportion to their respective abilities; that is, in proportion to the revenue which they respectively enjoy under the protection of the state.~Adam Smith, The Wealth Of Nations
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