How Are Incentive Stock Options Taxed?

Incentive stock options are frequently offered to executives and are a great way to build wealth, but one needs to consider the tax consequences when developing their exit strategy. Proper planning and tax management strategies can save you tens of thousands of dollars in taxes.  

Capital gains on stocks fall into two categories, Short-term and long-term. Short-term capital gains apply to stocks that are held less than one year and are taxed at the taxpayer’s ordinary income tax rate. Long-term capital gains are for stocks that are held greater than one year. These long-term gains are taxed at lower more favorable rates of 0%, 15%, or 20% depending on your income level for that particular year.

Incentive stock options (ISO) are not taxed when granted, when vested or when exercised. They are taxed when you sell your shares. An additional tax benefit of ISOs is that they are taxed at the more favorable long-term tax rates if you sell the stock more than one year from the time you exercised the ISO and if your sale date was greater than two years from the time you were granted the ISO. The ISO is considered disqualified and treated as earned income which is taxed at your ordinary tax rate if both criteria are not met. Thus, it is important to meet both criteria and have your gains taxed at the more favorable long-term capital gains rates. This can save you thousands of dollars in taxes. Always talk to your financial planning consultant or tax management consultant to make a detailed plan.