Using a stock option can provide significant leverage for growing your money and making better, more strategic financial decisions. However, the difficult question is when to exercise a stock option.
Some people try to hold the option for as long as possible – they believe that the market will only ever turn in their favor. Others try to exercise as soon as the return on investment becomes favorable. While the right time for you will depend upon your risk tolerance and financial goals, waiting too long to exercise your stock option could have more impact than you realize.
Why Exercising Your Stock Options Depends on Timing
When you decide to exercise your stock options, first you’ll need to calculate a variety of influential factors. The longer you wait, the more expensive it may be to exercise. Being patient, however, and waiting to exercise your stock option could also benefit you. For example, you may benefit from a significant increase in the stock’s price – which can mean more growth for your overall Return on Investment (ROI), too. The decision to exercise a stock option is nuanced one. It should take into account your financial goals, the potential taxes you will pay and more.
Increases in the Alternative Minimum Tax
Keep in mind that when you exercise a stock option, you typically have to pay Alternative Minimum Tax (AMT). AMT is based on a calculation of your transaction. You can figure out how much AMT will be due by looking at the stock’s share price at the time that you choose to exercise. Determine the difference between the current share price and the exercise price (in other words, the price that you paid when you purchased the stock option). To calculate the taxable event, multiply that figure by the number of shares exercised.
From there, assume that roughly 28% is attributed to AMT. As you can see, exercising early, when the difference between your exercise price and the stock price is small, results in less AMT owed. If you wait too long to exercise, you may see impressive gains on the stock-but you will also pay significantly more in alternative minimum tax.
Your Own Assets Factor In
It is also important to keep in mind that your stock option is not just an imaginary set of numbers. You will need to back your purchase with your own assets. The longer you wait to exercise, the more the AMT climbs. Furthermore, the higher the stock price may climb. This is advantageous because you have the potential to buy a very successful stock for a low price. However, you still need to leverage your assets to buy shares.
For some investors, finding tens or even hundreds of thousands of dollars to cover both the price of the shares and the cost of the AMT due to be paid to the IRS can be a challenge. Not everyone has that sum of money lying around. Exercising early not only lowers the alternative minimum tax due but keeps the bill more affordable for the entire transaction.
The 83(b) Election Option
Another critical element to keep in mind is the potential to file an 83(b) form. If you exercise when the strike price of the shares is still close to the market price of the stock, you have 30 days to file form 83(b). Doing so will request that the IRS note this transaction as income-which is ideal, because you want the IRS to request taxes on the smallest transactions possible, before your shares appreciate. In this way, you can often avoid paying significant taxes by using the 83(b) election option.
Your timeline to file an 83(b) form is small: 30 days after you exercise. Move quick if this is the route you want to pursue. Of course, waiting too long to exercise your stock option could remove this choice if the price of the shares far outpaces your strike price. You can speak to a professional at any time during your stock option holding to strategize and make a plan of action through investment planning.
Trust the Professionals to Help You Decide on the Right Time to Exercise
Whether you are considering a stock option or you have already signed the agreement and want to know if you should exercise, it’s wise to seek help from the experts. The professionals at Inflection Advisors would be happy to help you achieve financial success by evaluating your short- and long-term goals, risk tolerance and more. Reach out to schedule an appointment to get started, or to ask any questions that you may have about stock options and the taxes they can accrue.