If you are holding an employee stock option then you must be knowing that there are two types of employee stock options - 'Non-Qualified Stock Options' (NQs) and 'Incentive Stock Options' (ISOs).
Both of these stock options have been taxed differently, in this article, we will discuss the way in which both the account is being taxed in detail.
Taxation Methods For Not Qualified Stock Options
When you have a non-qualified stock option, the concept of ordinary earned income is there which is the difference between the market price of the stock and the grant price(also called the spread) is counted, and it does not matter whether you exercise your options and continue to hold the stocks.
Earned income comes from the payroll taxes which is the combination of Social Security and Medicare, as well as subject to regular income taxes at the rates which apply to you.
Two types of payroll taxes which you would be paying are as given below:
Social Security (Also called OASDI) –
It is applicable at the rate of 6.2% on the earnings up to the Social Security benefit base which is $118,500 as in the year 2015.
Medicare (Also called as HI) –
It is applicable at the rate of 1.45% of the earned income even in the case the amount exceeds the benefit base.
In case you have earned the income in a year which is already exceeding the benefit base than your payroll taxes on gain which got generated from non-qualified stock options, then it will be just 1.45% which will be cost to the Medicare.
When you got the income from non-qualified stock options, then you will need to pay a total of 7.65% on the amounts which will be gained and until the time when you earn the income which reaches the benefit base than 1.45% on the earnings over the benefit base.
Make it imperative that you should not exercise your employee stock options which are strictly based on the tax decisions; in fact, you should keep in mind that if you are exercising non-qualified stock options in a particular year in which you have failed to earn any other income from other sources.
You will also pay more payroll taxes than you will pay if you chose to exercise them in the year where you do not have other income sources and already to exceed the benefit base.
There are also additional taxes besides payroll taxes that is the gross income which you have earned is subject to ordinary income taxes.
If you chose to hold the stock after deriving the benefits and also the additional gains you have achieved more than spread, in that case, these additional gains could be taxed in the form of capital gain. And in case the stock went down it will come under capital loss.
For additional details on this, you can always read related articles on the internet where you can educate yourself about tax guide for the investments which you have planned to make and also you can get additional details about tax which are applicable when you choose to exercise non-qualified stock options.
Taxation Methods On Incentive Stock Options
These are different than non-qualified stock options as the gain on incentive stock options don't come under the payroll taxes, but that does not mean it is tax-free some different taxation methods are applicable in this case, and it is preferable when considering AMT, i.e. 'Alternative Minimum Tax' calculations.
When you are holding and exercising and incentive stock options then there can be few different tax possibilities which are described as below:
If you have opted to exercise the incentive stock options and planning to sell the stocks within the same calendar year then in that case - the tax which will apply to you will be the difference between the market price at the time of sale and the grant price which will be applicable at your ordinary income tax rate.
If you have decided to exercise the incentive stock options but at the same time, you opted to hold the stock –
In this case, the difference between the grant price and the market price becomes an item preferable by AMT (Alternative Minimum Tax).
The main advantage of this could be you are credited with the excess AMT tax which you have paid, but also you should understand that to use this credit you need to wait for many years.
If you have opted to hold the share for at least one year from the date it has been exercised & two years from the grant date option,
In this scenario, the difference between the grant price and the market price at the time when you sell the options will be taxed as a long-term gain and will not be taxed as ordinary income.
In the case, if your average tax rate exceeds your AMT tax rate, you can have the option to use AMT credit which was accumulated in the past.
If you are earning at the high rate and opted to hold the stock as per the required period, it means you were going to pay tax on the gain at 15% rate as compared to 35% rate, but before doing so you must always evaluate all the risks involved in this strategy.
Tax rules are always complicated and many times difficult to understand. So if you are also unable to comprehend the tax rates, you can always get the help from a competent tax advisor or financial planner so that you can clear estimates and understanding of the taxes.
And then you can understand what will be your final income after paying all the taxes?
This experts and professional will also guide you with when to exercise your options so that you can manage to pay the least tax possible.