Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Incentive Stock Option (ISO)

What it is:

An incentive stock option (ISO) is the right but not the obligation to purchase shares of a company, usually the option holder's employer, for a fixed price by a certain date.

How it works (Example):

Option grants are incentive compensation that encourages employees to focus on doing work that increases the stock price and thus shareholder value, which is the primary objective of all businesses. A company's board of directors normally must approve option grants. The value of these options is derived from the price of the employer's stock.

Let's say you work for Company XYZ, and the company grants you options to buy 1,000 shares for $40 a share in the next 10 years. If Company XYZ shares rise to $60 and you have the right to buy shares for $40, you could exercise your options, pay $40,000 for your shares ($40 x 1,000), and turn right around and sell them in the open market for $60,000. You'd make $20,000 of easy money. However, note that the stock options are only valuable if the stock is trading above $40 per share before the options expire. Usually, companies grant options with strike prices above the current market price.
 

Why it Matters:

There are two primary kinds of employee stock options: nonqualified options (NQOs) and incentive stock options (ISOs).

Holders of ISOs generally don't pay taxes when they exercise their options; instead, they pay capital gains tax on the difference between the exercise price and the price at which you eventually sell your stock.

So, let's say that three years after your 1,000-option grant, Company XYZ stock is up to $60. You decide to exercise even though only 600 of your options are vested. If you sell the shares immediately, you make a profit of 600 x ($60 - $40) = $12,000. But, you pay short-term capital gains tax on that profit, which is, say, 35%, or $4,200.

On the other hand, if you exercise and then hold onto the stock for, say, five years before selling them at $60, you still make a $12,000 profit, but now you pay long-term capital gains tax, which is, say, 15%, making your tax bill $1,800.