Know Your Tax Ramifications When Exercising Stock Options
Many companies offer their employees stock options, or an opportunity to buy a certain number of shares in the firm, as a benefit. To make this benefit attractive to its employees, companies typically allow the recipient to buy the shares at a discounted rate known as a grant price. If you are fortunate enough to have stock options as part of your compensation plan, you are likely to enjoy a financial windfall when you decide to exercise them.
Selling to cover is a common strategy you may use in exercising your options. When you sell to cover stock options, you exercise your options by selling your shares at a market price that is higher than your grant price. This tactic allows you to end up with the proceeds of more shares than when you started, giving you a net profit. While this is a positive outcome, it also requires some calculation because there are tax implications of selling stock options.
Measure Your Gains
The first step is to determine the amount of money you gained when selling to cover. Do this by subtracting the total grant price from the proceeds of exercising your shares. For example, say your original option included 100 shares at a grant price of $50 per share. Also presume your shares are fully vested, meaning the options are yours to exercise at any time you want. If the market price of the shares is now $75, for example, then selling all 100 shares to cover would generate proceeds of $7,500. The total grant price was $5,000, or 100 shares at $50 each. Subtracting $5,000 from $7,500 gives you a gain of $2,500.
Apply Your Federal Income Tax Rate
Next, apply your federal income tax rate to the gains you realized. The most important factor to consider is that your profit is taxed as ordinary income rather than as capital gains. Even if it took several years for your options to fully vest, which is typical, you are not permitted to choose the lower capital gains rate, which is 15 percent for most taxpayers. Staying with the example from above, if you are in the 28-percent tax bracket, then you would owe the IRS $700 on the $2,500 you profited from selling to cover. You get that figure by multiplying $2,500 by .28. That would still leave you with an overall net gain of $1,800 in your pocket.
Best Course of Action
Even though selling to cover leaves you with some tax liability, it is usually your best course of action. Avoid the common pitfall of exercising your stock options but hanging onto the shares in hopes they will go even higher. If you hold onto the shares instead of selling to cover and the share price drops, you are still on the hook for the original gain. In the example from above, say you exercise your options at $75 but do not sell to cover and the market price later falls to $25. If you sell at that point, you still owe taxes on the original $2,500 gross gain. It is better to sell to cover, pay the income tax and book the net gain.