How to Calculate Income Tax on an Option Sell to Cover

  Reviewed by: Ashley Donohoe, MBA      Updated November 27, 2018
  Written by: Steven Melendez

If you have stock options or restricted stock units from your employer, they're part of your compensation and ultimately subject to tax. When you exercise stock options, the discount on the shares you get is taxable, and when restricted stock units you receive from work vest and you actually own the stock, the value of that stock is taxable income. In some cases, you may sell some of your stock to cover the RSU tax and other costs on stock options.

Sell to Cover Option Costs

Employee stock options typically give you the right to buy company stock at the price the stock was valued at when the options were granted. You normally have a certain window to exercise the options, after a vesting period and before the options expire.

There are two types of employee stock options: incentive stock options and nonqualified stock options. For incentive stock options, you do not have to pay tax when you exercise the options. Instead, if you hold the stock for at least a year after exercise and two years after the options were granted, you can simply pay long-term capital gains tax when you sell the stock.

For nonqualified stock options, you pay tax on the amount of the discount you receive when you exercise the options. So, if you exercise the right to buy 100 shares of company stock at $25 each, and the stock is currently trading at $60 per share, you pay tax on the $35 x 100 = $3,500 difference in price. This is considered ordinary income, not capital gains, so it's taxed according to your ordinary income tax rate.

Your employer must withhold taxes, as with other forms of compensation. Since the options are considered supplemental income, similar to a bonus, this will often be at a fixed percent supplemental income rate, though you ultimately may pay less in tax on the income depending on your tax bracket.

You are generally required to come up with the funds for your employer to withhold, since it cannot withhold stock to pay the Internal Revenue Service. You can either provide funds from a bank account if you have the money or sell some of your stock to cover the taxes and any other expenses, like the actual stock purchases and any brokerage fees involved. This procedure is known as "sell to cover," and your employer or the company that administers its stock option plan can often help you compute your tax withholding and how much stock you need to sell.

If you have a choice between paying cash or selling stock to cover the option costs, consider whether you expect the stock to continue rising in price faster than your cash can earn money in other investments. In that case, you might want to use more cash and sell less stock than if you expect you can make more money using your cash other ways.

Sell to Cover RSU Tax

If you received restricted stock units instead of stock options, the concept of a "sell to cover" is similar. You're generally taxed on the value of the stock when it vests as ordinary income, and you may sell some of the stock to cover your withholding tax. Work with your employer to determine how much withholding tax you must pay and to arrange the sale of stock for that purpose.

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2018 Tax Law Changes

With tax brackets ranging from 10 to 37 percent, ordinary income tax rates are generally lower for 2018 than in previous years, so you may end up ultimately owing less in tax on stock options you exercise and restricted stock units that vest in 2018. The supplemental income withholding rate for 2018 is 22 percent for bonuses, stock and other special pay under $1 million and 37 percent for income in excess of $1 million.

2017 Taxes and Stock Compensation

Tax bracket rates were higher for 2017 than 2018. This may have affected some employees' choices about when to exercise stock options that didn't expire before the end of 2017. The supplemental income withholding rate for 2017 was 25 percent for income under $1 million and 39.6 percent for income above that threshold.

About the Author

Steven Melendez is an independent journalist with a background in technology and business. He has written for a variety of business publications including Fast Company, the Wall Street Journal, Innovation Leader and Ad Age. He was awarded the Knight Foundation scholarship to Northwestern University's Medill School of Journalism.

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