While most employees receive wages in the form of paychecks and the occasional bonus or commission, some get an alternative form of compensation: stock options. Unlike many more traditional ways to provide incentives or a variable part of a compensation package, stock options can be complex—particularly at tax time.
To help you avoid any unnecessary taxes, here are four key things to do before exercising your stock options.
1. Strategize Buying and Selling
The exercising of stock options may generate two types of taxable income: both when exercised and when the stock is sold. The exercise may result in effective income reported by your employer while the sale will produce taxable income along with any other investments. This last tax rate varies depending on how long you held the stocks. The entire transaction then should be part of a single strategy of timing.
2. Ask About Tax Reporting
You or your accountant should discuss the method by which the exercise of stock options is reported by the employer. The discount you received when purchasing the options is often reported on your Form W-2 as part of your compensation. But it may also appear in Box 12 for informational purposes. Failure to recognize this leads to overreporting by unaware employees.
3. Track Your Tax Basis
Any amount of money you pay for an investment is subtracted from the proceeds to find the actual profit. The amount paid is known as the tax basis. With stock options, this involves a little calculating. You may need to know not only what you paid for the stock options on the day you bought them but also what the discount was if it was reported on your Form W-2. To avoid unnecessary taxes, keep track of all related information in a file for use by your tax preparer.
4. Learn About the AMT
The Alternative Minimum Tax (AMT) is designed to help capture some taxable income that might not otherwise be included as taxable due to certain deductions. Stock options commonly trigger this additional calculation, which can change how much tax you owe. Because the AMT rarely affects taxpayers, you may need to understand its basics in order to avoid higher taxes.
Where to Start
If all this sounds complicated, it's not just you. Stock options are usually unfamiliar and subject to specific tax rules and few people have experience with them. So if you expect to get these from your employer in the future, start by learning more about these important steps and more. Meet with a certified public accountant (CPA) in your state today.