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I just read the Q&A on nonqualifed stock options. It made me wonder if the tax laws do not provide and incentive to exercise options sooner rather than later.

Consider the following example:

Suppose I am granted an option to buy 5000 shares of my company's stock for $10.

Three years later, the stock is selling for $20.

Suppose I exercise the options and sell the stock three years after the options are granted. My total tax bill--assuming that I am in the highest tax bracket--is $19800.

If I had exercised the options as soon as possible, say after one year, when the price was $13, my tax bill would be much lower:

.396*3*5000 + .2*7*5000 = $12940.

This is a big difference! The incentive to exercise options sooner was sweetened when the capital gains tax rate was cut last year.

I understand that there are other considerations, mainly that you have no downside risk with options, but you do with stock.

Nevertheless, I have never seen any articles that mention the effect I described above.

Any thoughts on this would be welcome.
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In the interest of conserving space I will not quote your question below but merely indicate my agreement with your analysis. Exercising a nonqualified stock option earlier -- before a substantial increase in the value of the stock -- means reporting less ordinary income and more capital gain, with substantial tax savings as a result. Apart from the downside you mention (risk that the stock will decline in value) there are other considerations such as (on the negative side) having to come up with the money to exercise sooner and having to pay the tax sooner, and (on the positive side) receiving dividends sooner.

KAT in Chicagoland
Tax Guide for Investors
Now featuring Roth IRA information
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Sandblster poses an interesting question about whether you're better off exercising an option today, taking the tax hit at the short term rate and holding for the long term rate OR exercising later and taking the entire gain at the short term rate. Using his example:

You have an option to buy 5000 shares for $10/each. Three years later, the stock is selling for $20. Suppose you exercise and sell three years later. In the highest bracket, and assuming no state or FICA taxes, your tax bill is $19,800 ($50,000 gain times 39.6%). Total out of pocket is $69,800 and your net profit is $30,200 ($100,000 less $50,000 less $19,800).

That's the wait three years scenario. If you exercise after one year ($13 stock price) and hold for the next two, then close out the transaction, the numbers look like this:

Year one: $50,000 out of pocket to exercise option. Profit of $15,000 ($3 times 5000). Taxes of $5,940 ($15,000 times 39.6%). Total out of pocket is $55,940.

Year three: Sell 5000 shares at $20, for a gain of $7/share or $35,000 and taxes due of $7,000.

At first glance this sounds wonderful. For the first scenario you made $30,200; for the second you appear to have made $37,060 ($100,000 less $55,940 less $7,000), an improvement of $6,860.

BUT (and here's the killer) to do the second scenario you had to come up with $55,940 at the end of year one. What's the opportunity cost of that? If you had to borrow it, any rate over 6 % puts you worse off than scenario one (Two years interest on $55,940 at 6% = $6,914). If you came up with the money out of your own pocket, is a 6 % after-tax return the best you could do with your money? (And of course none of this address the risk issue - the reason I like options is it's as close to riskless as the government allows.)

You example sounds wonderful, and maybe some would say you're better off under option two, but for my money I'd stick with option one. I think I could do better things (with less risk) with $56k than get a 6% return.
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Thanks for your thoughts on the question I posed. I agree with your analysis--the opportunity cost of exercising today rather than a few years out probably is substantial.

I suppose the upshot of my message is that employer granted options, although great, are not necessarily as lucrative as people may think. I know a number of people who did not realize they were taxes when exercised at their marginal income tax rate. A rude surprise!
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You have to excuse me for a moment, i am new to Motley Fool and I am having trouble navigating though the various messages in this folder on stock options. The tax consequences of selling ealry may be offset if the stock should go up enough over time and only you can tell how high the stock will go. I have a different scenerio and would love input on. I have alot of stock options that i can sell, but i will be hit hard on taxes (they are NQO and I am in a high bracket), but the stock after a great runbeen stalled for about 14 mosis not going up.

Questions: Should I sell, pay the taxes and put the money in some investments that will increase my retrun?
Should I hold on and risk a bad quarter will drop the price and then i loose the gain (which would have paid the taxes) and sell after i leave the company in the beginning of Y2000 with a lower yearly income and pay less taxes?

A little info on the stock - PE is 50 with 25-30% yearly growth. Options are priced at 7 and can sell them at 40.

Any comments would be appreciated.
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