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No one's excited about the possibility of paying higher taxes. For employees who get a big part of their compensation through stock options, however, a future tax hike could mean a big bill in the years to come -- if you don't take steps to minimize the damage right now.

Not just for the C-suite
Whenever someone talks about stock options, most people think of high-paid corporate executives and the millions in compensation that many of them receive. It's true that some of the highest-paid CEOs, including Apple's (Nasdaq: AAPL  ) Steve Jobs and former UnitedHealth Group (NYSE: UNH  ) CEO William McGuire, have received huge amounts of wealth from owning stock options when share prices have been on the rise.

However, there are plenty of places where rank-and-file employees also get at least some benefit from stock options. Technology firms like Microsoft (Nasdaq: MSFT  ) and Cisco Systems (Nasdaq: CSCO  ) were noted in the late 1990s for granting stock options to ordinary employees, making many of them rich during the tech-driven bull market that led to the Internet bubble. But you can also find stock options outside the technology sector, at companies including Starbucks (Nasdaq: SBUX  ) , Southwest Airlines (NYSE: LUV  ) , and PepsiCo (NYSE: PEP  ) .

After 2008's bear market, thinking about how profits on stock options might impact your taxes was largely a moot point, as most stocks were suffering huge losses and leaving any options that employees owned essentially worthless. But with some of the big gains that stocks have enjoyed in 2009, longtime holders of stock options may suddenly find themselves with decent gains again -- much of which could fall into the hands of the IRS without proper planning.

The danger of stock options
Although stock options align the interests of employees with shareholders', they come with tax complications for workers who receive them. One type, known as nonqualified stock options, has two taxable events associated with it. When you first exercise your option and receive shares, you generate taxable income equal to the difference between the current market price of the stock less the smaller amount you have to pay for shares under your option contract. After you exercise, any further gain gets preferable long-term capital gain treatment if you hold onto the shares for more than a year.

In contrast, incentive stock options don't create regular tax liability when you exercise them, although they can be subject to alternative minimum tax. If you hold them for more than a year after you exercise them, the entire gain is eligible for capital gains treatment -- even the portion that came from before you exercised your options.

Ordinarily, stock options provide a form of tax deferral, and workers are well-advised to wait as long as possible before exercising them. But with concerns that tax hikes will come in the near future, some advisors are recommending that employees with stock options exercise them now to capitalize on current low tax rates.

In 2011, rates are scheduled to rise as much as 4.6 percentage points on high-income taxpayers, and the administration has proposed a surtax that could effectively raise the top federal marginal rate to 45%.

Exercising now would mean that you'd pay taxes sooner than necessary, which would take away the benefit of a few years of tax deferral between now and whenever your options require you to exercise them. But the difference between paying 35% or less now versus potentially paying as much as 45% or more in taxes in the future may well outweigh the benefits of tax deferral.

Weigh your options
With future tax law as uncertain as it is right now, it's impossible to be certain what your tax rates will look like in the future. Taking an extreme position in either direction could turn out to be costly if law changes move against you. A middle-ground approach might be the most prudent way to hedge your bets.

If you're fortunate enough to have stock options that have risen in value, you have some important decisions to make. Although no one likes to pay taxes before they absolutely have to, biting the bullet a bit early may end up saving you a ton of cash in the long run.

It's that time again. Get the help you need to fight the IRS with The Motley Fool Guide to Doing Your Taxes.

Fool contributor Dan Caplinger was in the right place at the right time -- Seattle in the late 1990s -- but picked the wrong employer. He owns shares of Starbucks. Microsoft and UnitedHealth Group are Motley Fool Inside Value recommendations. Apple, Starbucks, and UnitedHealth Group are Motley Fool Stock Advisor selections. PepsiCo is a Motley Fool Income Investor selection. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool owns shares of UnitedHealth Group. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy gives you all the options.


Read/Post Comments (1) | Recommend This Article (5)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 28, 2010, at 10:16 PM, myStockOptions wrote:

    In most cases paying the tax taxes early does not make sense. When you analyze whether to exercise the employee stock options, sell the stock, and invest the proceeds from an NQSO before there is a rise in the ordinary tax rate, the results can be counterintuitive: just a modest increase in the stock price over the remaining option term can make waiting to exercise a smarter decision than execising merely for lower taxes in 2010. Look at your after-tax gain in both situations, along with the expected gains on investing the proceeds, and not just the total taxes paid.

    Only when you would need to exercise the options within one or two years to avoid their forfeiture, or you think the stock price is headed downward, does the tax change alone lead to exercising now. The tax deferral advantages of waiting to exercise and the leverage it brings remains the powerful attractiveness of employee stock options. The exercise and hold decision can be different when you have incentive stock options, as the full spread at exercise can eventually be taxed at capital gains rates (putting aside the AMT issues).

    There are tools and a three-part article series on www.myStockOptions.com that looks at strategies for handling the tax increase related to whether to exercise NQSOs, ISOs, and whether to keep holding stock that was exercised or vested. Look in the Financial Planning: Advanced Strategies Section, see:

    http://www.mystockoptions.com/articles/index.cfm/secID/03B17...

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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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