In the 4th of our 6-part series for tech professionals,we dive into the world of Incentive Stock Options (ISOs), focusing on how tech professionals can leverage them. Amy Walls from Thimbleberry Financial breaks down ISOs as a form of equity compensation, allowing employees to buy company stock at a favorable price, known as the exercise price. The unique advantage of ISOs lies in their tax treatment. If handled correctly, through what's called a qualifying disposition, the profit from the sale of these stocks is taxed at the capital gains rate, rather than the higher ordinary income rate.
Amy emphasizes the importance of timing for achieving a qualifying disposition. There must be at least one year between the grant and exercise dates, and another year between the exercise and sale dates, totaling a minimum two-year holding period. Failure to meet this timeline results in a disqualifying disposition, subjecting the profit to ordinary income tax rates.
Strategic planning is crucial for maximizing the benefits of ISOs. Amy suggests considering the market price when exercising options, as this can affect the alternative minimum tax (AMT). Exercising when the market price is low can minimize AMT, potentially leading to significant tax savings. She also advises against using shares to cover the exercise price, as this could lead to a disqualifying disposition.
Amy shares success stories of tech professionals who've strategically used ISOs to enhance their financial journey. One individual, referred to as Mark, meticulously planned his ISO exercises and holding periods, resulting in substantial long-term capital gains and contributing significantly to his financial independence. Another example involves Brenda, who initially hesitated to exercise her options during a market dip. However, after understanding the tax implications, she realized exercising more shares could save her $30,000 in taxes.
For tech professionals looking to incorporate ISOs into their retirement plans, Amy underscores the importance of planning and working with financial and tax professionals familiar with ISOs. Understanding the specifics of your company's ISOs and how they fit into your overall financial plan is essential. She also highlights the need to be aware of how shares will be treated at retirement, as some companies allow for continued vesting or immediate vesting upon retirement.
In summary, ISOs offer a valuable opportunity for tax-efficient growth and financial planning, but they require careful strategic planning and professional guidance to fully capitalize on their benefits.
ThimbleberryU 109 - Tech Professionals 4 of 6
Speakers: Jon Jag & Amy Walls
Jag:
Welcome back to ThimbleberryU, I am Jon Jag Gay. I'm joined as always by Amy Walls from Thimbleberry Financial. Amy, great to be with you.
Amy Walls:
Jag, it's good to talk to you.
Jag:
Today's the fourth episode in our six-part series dedicated to tech professionals. Amy, I know it's an area that you specialize in at Thimbleberry, and today, we're talking about ISOs (Incentive Stock Options). What are they? Where do we start?
Amy Walls:
So, I'll probably refer to incentive stock options today as ISOs. ISOs also is a common name. These are a unique form of equity compensation where an employee is given the opportunity to buy company stock at a favorable price. That price is called the exercise price.
So, let me give you an example. Let's say I'm the employer and you're my employee, and either as part of a bonus or performance or perhaps a hiring bonus, I say, “Hey Jag, I'm going to give you these incentive stock options.” And so, maybe I say, “Here's a thousand, they're going to vest over the next four years, and you have the ability to buy shares of company stock now at $2 a share.”
So, the cool thing about these isn't just that you can buy the stock at $2 a share, but when you sell the stock, if you do it in the right way, you're going to get a preferential tax rate. If I'm the employer and you're my employee, almost everything we do gets taxed as ordinary income, just like a paycheck.
These can be taxed that way, if not executed properly. But if they're executed properly, which is called a qualifying disposition, then you actually get capital gains tax on the growth.
Jag:
The capital gains tax rate, got it, okay.
Amy Walls:
Yes.
Jag:
So, if I'm understanding you correctly, there is a bonus on the frontend and the backend, and that you have the option to buy the stock at a reduced rate, and then if, and when you sell the stock, again, predicated on you doing it correctly, as you said, you're getting taxed at a capital gains rate as opposed to the normal tax bracket.
Amy Walls:
Correct. Yep. And your growth for that tax is the difference between the exercise price and what you sell the stock for.
Jag:
Okay.
Amy Walls:
So, if you buy the stock at the exercise price of $2 a share and you sell it for a hundred dollars a share, so that's a $98 difference.
Jag:
So, that's the growth you're taxed on, got it. Okay, what else?
Amy Walls:
So, one of the details here is about your holding periods in order to get this qualifying disposition. Basically, what that says is from the time I say, “Hey Jag, here is this notice of grants, we're granting this to you, these a thousand shares that are going to vest in four years,” there has to be one year (more than one year) between the date they are granted and the date you exercise. And then there needs to be more than one year from the date you exercise and the date you sell.
Jag:
So, we're talking a two-year period total?
Amy Walls:
Yes. At a minimum, if you executed it perfectly, it's going to be two years and a day essentially, in order for that to happen.
Jag:
Minimum two years, got it.
Amy Walls:
Minimum two years. If you don't meet those two one-year periods in order to get to the full two years and you can't do one at six months and one at 18 months, it's a year to year — then you get what's called a disqualifying disposition and that's where you're going to pay normal income tax on the growth of $98 a share.
Jag:
So, again, I'm not a financial professional, but my background as a broadcast journalist, a qualified disposition, and a disqualified position, those are the opposite things.
Amy Walls:
Absolutely.
Jag:
I just wanted to make sure I had that right.
Amy Walls:
Yep. And what they're saying is in a disqualifying disposition, you're going to pay more in tax, and on a qualifying disposition, you're going to pay capital gains tax rates.
Jag:
You've almost disqualified that perk is probably a good way to remember it.
Amy Walls:
Exactly.
Jag:
Okay. Amy, how can tech professionals exercise ISOs strategically to maximize these advantages?
Amy Walls:
So, strategic planning is definitely essential here.
Amy Walls:
First and foremost, I have to say that anybody with these ISOs should consider their financial goals and tax implications. But one strategy that often throws people for a loop, I've definitely had conversations with clients, they're like, “No, the stock price is low, I shouldn't exercise right now.”
Well, it can make sense to exercise when the market price is low versus high. Yes, you're not getting as big of a discount in your purchase price, but exercising incentive stock options is a trigger for alternative minimum tax.
And so, when that gap is smaller, it can make the alternative minimum tax smaller. And then if you're still waiting to sell, your growth could still be the same amount.
Jag:
I see.
Amy Walls:
So, you can save on the alternative minimum tax if you exercise when the stock price is lower.
Jag:
So, you're not getting as steep a discount, but your advantage is on the backside on the alternative minimum tax, got it.
Amy Walls:
Yeah. So, let's go back a couple of years, tech stocks are down overall, somebody may have these — well, it's not just that the company is doing poorly, it was that tech stocks just in general are doing poorly.
So, we can expect that they're going to rebound versus if this is company-specific. And so, that's a great example of where, okay, this is industry versus company, and so I'm not so much at risk that this is an isolated issue with my employer. And so, I can buy these with the expectation really that this stock price in general is just going to go back up as the market recovers.
Jag:
Sure, okay.
Amy Walls:
Another thing, I mentioned alternative minimum tax and the example I just gave is a great way of minimizing alternative minimum tax. I should say that as a strategy, it's also just important to be mindful of how many shares you may be exercising in any one year and what that might do in terms of triggering alternative minimum tax.
Jag:
Got it, okay.
Amy Walls:
So, that's part of why planning is essential.
And then the other thing that a lot of our tech folks get used to is when they're selling non-qualified stock options, they'll just use shares to exercise. So, basically, what I'm saying there is if they have a hundred shares vesting, they may say, okay, I am exercising these shares but they use some of the shares to pay for the exercise price, and so they end up with less shares.
Jag:
Oh, okay. Got it.
Amy Walls:
Okay. With an incentive stock option, you don't want to do that, because if you do that, the shares that get sold to cover the price are going to be a disqualifying disposition, meaning that higher tax rate.
Jag:
So, use cash in that situation or a cash equivalent.
Amy Walls:
You've got to plan ahead to make sure you have all the cash you need in order to buy the shares.
Jag:
Got it. So, we've spent the first half of the podcast sort of giving the overview of ISOs here. Just to crystallize it for our audience, Amy (well, and to be honest for me), can you share some stories of tech professionals who have used these ISOs to enhance their financial journey?
Amy Walls:
Absolutely. Let me tell you about Mark, at least, we'll call him Mark. He's a tech professional I know who strategically exercised his ISOs over several years. So, we laid out a plan of here's the strategy, and by timing those exercises thoughtfully, and then planning to hold the shares for the required holding period after that, he was able to enjoy these favorable long-term capital gains tax rates.
Now, the proceeds from the incentive stock options played a significant role in his life. He bought a property that had a lot of value, both sentimentally and in the form of entertainment from vacations, and really, accelerated his path towards financial independence, which is something a lot of our folks in tech are really looking to do.
Jag:
Sounds like he followed all the rules you outlined earlier.
Amy Walls:
Yes. And so, we had a strategy, it was laid out. That doesn't mean we just followed it exactly, but because we had a plan, we could look each year at our plan and say, “Does this work? Are there market conditions that make it favorable to exercise more or exercise less right now in order for you to meet these goals.”
And along the way, being able to buy the property and add to accounts for financial independence, really, Mark was able to diversify quite a bit.
Jag:
It speaks to something we've talked about in previous episodes, that a financial plan is not just set it and forget it. You want to check in every six months, every year, whatever that time period is to make sure what you're doing is in track with your goals and make any adjustments as needed. We probably got time for one other example if you want to give me another one, Amy.
Amy Walls:
Yeah. Someone comes to mind, I will call her Brenda. So, we set up a schedule for her to exercise before the grants expired because that's something we haven't talked about, Jag.
These grants have a point in time at which they no longer have value. They just disappear. So, we want to be cautious of that expiration date. So, the stock price dropped, and Brenda kind of alluded to this earlier, didn't want to exercise because she was thinking I'm going to lose money.
She actually came in and said, “I know I'm supposed to, but I shouldn't. I'm not going to, like this would be a loss of money.” And I showed her how exercising more shares than what was in the plan actually saved her money. And it was about $30,000 in taxes.
Jag:
Wow, okay.
Amy Walls:
So, once we walked through that and kind of compared the scenarios and how the math worked, and that in the end, she could still sell them for the same price, she was completely on board with that decision.
Jag:
I bet, yeah.
Amy Walls:
Yeah, she was on board, she was comfortable, calm, and shocked that it could be the complete opposite of what she expected.
Jag:
Gotcha. So, last question for you, Amy. Looking forward for our tech professionals listening today, how can they incorporate ISOs into their retirement-focused financial plans?
Amy Walls:
ISOs are a perfect retirement asset as long as you've planned ahead. And why I say that is they're just like, in a sense, extra money, extra cash coming in from your employer: big bonuses, that sort of thing.
So, as long as you have a plan for where to put them, they're a great tool. If they disappear into cash flow because you don't know where the proceeds are going to go, then they aren't as strong. In fact, they might hurt you because your expenses have just gone up without income going up.
So, really, it's a tool from the employer that gives you the ability to save on taxes compared to just a straight bonus. And they can be used to diversify your investment portfolio or create a source of tax-free income later on when you are financially independent.
But obviously, they do have a lot of tricks and things that you need to be aware of. So, I do think it is a good idea to work with both a financial advisor and a tax professional who are familiar with ISOs, and can work together to fit them into your overall plans.
One last thing that is important in incorporating them into retirement planning is, it's really important to know how shares will be treated at retirement. So, what I mean by that is I said these expire and they have vesting dates right along the way.
So, oftentimes you'll see that a grant will expire 10 years after it's given. So, let's say these shares are vesting over four years, Jag, and I've just given you the same example we talked about earlier — a thousand shares, $2 a share in terms of exercise price, and you retire two years into this grant.
Well, in most cases, if you just left the company, all the rest of the shares that haven't vested are going to disappear. And you would've had about usually 90 days to exercise after leaving. So, that can be stressful.
But at retirement, sometimes a company will say, “Hey, if you've met certain criteria, we're still going to let these vest or they will vest a hundred percent at your retirement date.” So, knowing that information so that you can plan if you are close to retirement is really important. And in leaving the company, knowing you're going to have the money available in the right spot in order to exercise.
Jag:
So, really, two takeaways here, Amy, are that it's crucial to one, have as much information as you can about the specific ISOs you're being offered within your company and how the different permutations that work, but then also, to work with a financial professional as you've just demonstrated, someone who really knows their way around this space is so important.
If one of our listeners wants to contact you about ISOs or anything related to financial planning, how do they find you at Thimbleberry?
Amy Walls:
They can find us online at thimbleberryfinancial.com or they can give us a call at (503) 610-6510.
[Music Playing]
Jag:
Good stuff, Amy. We'll talk again in a couple of weeks.
Amy Walls:
Sounds good.
Jag:
Securities offered through registered representatives of Cambridge Investment Research, Inc, a broker dealer, a member of FINRA, SIPC, advisory services through Cambridge Investment Research Advisors, Inc, a registered investment advisor. Cambridge and Thimbleberry Financial are not affiliated.
Discussions in this show should not be construed as specific recommendations or investment advice. Always consult with your investment professional before making important investment decisions.
Securities offered through registered representatives of Cambridge Investment Research, Inc, a broker dealer, a member of FINRA, SIPC, advisory services through Cambridge Investment Research Advisors, Inc, a registered investment advisor. Cambridge and Thimbleberry Financial are not affiliated.