Choosing to Disqualify Incentive Stock Options (Thvera, Iceland)
Choosing to Disqualify Incentive Stock Options
Location: Thvera, Iceland Watch on YouTube
A Moment in Iceland
Hi, I am in Iceland—just walked along the Thvera River, I believe it is. It's a salmon fishing river in rural Iceland, and it is a beautiful day here.
A Tip on Incentive Stock Options
Today, I want to talk to you real quick about another tip regarding stock options—specifically, incentive stock options.
One thing to remember: once you exercise your incentive stock options, don’t assume you're going to be holding them for the next year.
The Holding Period and Tax Benefit
To get the tax break, you need to hold the shares for at least one year after exercising. That’s generally the default plan, and the goal is to benefit from a lower tax rate—the difference between a long-term capital gain rate and your ordinary income tax rate.
Here’s what to consider:
Long-term capital gain tax rates might be 15%, 18.8%, or 23.8%
Your ordinary income tax rate might be 22%, 24%, 32%, etc.
You need to:
Look at the spread between the two tax rates to determine the tax break.
Compare that tax break to the gain—this is the dollar amount you could potentially save over the course of a year.
Risk vs. Reward
You must hold all of the investment risk of the individual stock in order to qualify for that tax break. So ask yourself:
How much would the stock have to fluctuate for me to lose more money by holding the stock and getting a tax break, rather than selling it and paying higher taxes?
It’s important to continually assess whether the investment risk is worth the potential tax benefit.
AMT and a Declining Stock
Another critical factor to keep in mind, especially if the stock is dropping in value, is the Alternative Minimum Tax (AMT):
Once you exercise your options, you create Alternative Minimum Taxable Income (AMTI).This generates an adjustment that may require you to pay AMT in the same year.
Now, here’s where timing matters:
If you exercise in October, and December 31st passes, that AMT income is locked in—even if you disqualify the stock later. So if the stock drops in value and you eventually sell, you might not get the adjustment you want a year later.
That means you may not recapture the AMT credit or the AMT tax you paid in the first year.
What Should You Do?
After exercising:
Evaluate how much investment risk you want to continue holding. Decide whether to lock in AMT income at year-end, or whether it makes more sense to disqualify the stock.
Sometimes, the answer will be obvious. More often, it’s complicated—you may want help projecting outcomes to understand which numbers you’re dealing with.
Final Thoughts
Just be aware: once you exercise, it’s not a given that you’re going to hold for another year.
Thanks.