Nobody loves tax season. It’s complicated and it usually means it is time to cut a check on the money you’ve worked hard to earn. Once you start making income through the stock market on top of your other income, it becomes even more convoluted. One common question we get in particular is – how are stock options taxed when sold?
The answer to this question depends on a few factors – are you trading non-qualified stock options or incentive stock options? How long are you holding the options before exercising?
In this quick guide, we’re going to walk you through the basic information surrounding stock options and tax – including what you need to know about capital gains tax. We always recommend you hire a quality tax professional to guide you through this process – but in the meantime, this information will get you started on the right foot.
A Quick Explanation On Stock Options
First things first: what are stock options and how do they work? This type of trading varies from traditional stock market investing in that you are buying contracts for the right to buy stocks – rather than actual stocks themselves. We recently wrote a complete guide on stock options that is worth checking out if you’re diving into this world. For now, though, here is what you need to know:
Options give you the right – not the obligation – to buy or sell an asset. The price, the quantity, and the expiration date are all predetermined at the time of the contract. When you buy stock options, you are making an educated guess about what you expect to happen with that specific stock’s price. Before we can go further and give you an example, we need to discuss the two types of options:
- Call options – these contracts give you (the buyer) the right to buy stock at a strike price
- Put options – these contracts give you (the buyer) the right to sell stock at a strike price
Say you purchased a call option for a stock at a strike price (or exercise price) of $10 with an expiration date of 6 months. After 3 months, the price of that stock has risen to $15. You can either sell your contract for a profit right then and there. Or, exercise your option and actually buy the stock at your strike price – which means you’re essentially buying the stock at a discount.
What about put options, though? Let’s look at another example. Say you purchased a put option for a company or asset that you expect to drop in value over time. Your contract lists a strike price of $10/share and prior to the expiration date, the market price has dropped much lower than $10/share. You can now exercise your option to sell the stock at a premium. To learn more about swing trading options, take a look at our complete guide.
How Are Stock Options Taxed When Sold?
Now that you know more about stock options in general, it’s time to address the question at hand: how are stock options taxed when sold? The answer isn’t as simple as you may have hoped, as your options can get taxed two different ways: as ordinary income and as capital gains. Allow us to explain each of these for you:
Ordinary Income Tax
Let’s think back to the example we used above where you bought a call option for a company with a strike price of $10. When that market price rises to $15 and you exercise your options or sell your contract, you earn a profit of $500 since most options contracts are sold in lots of 100.
That $500 you made from exercising your options contract is taxed as ordinary income. But as you now know, you also have to think about the capital gains tax as well.
Capital Gains Tax
We talked a lot about capital gains tax in our guide on swing trading taxes. And if you consider yourself to be a swing trader, we highly encourage you to check that resource out – it will prove invaluable as you prepare for the upcoming tax season. But for now, how would the capital gains tax factor into the example we’re working with above?
Think about it this way: the capital gains tax only applies to the increase between the strike price when you bought the options contract and the price you sold your contract or exercised your option at. That means you owe capital gains tax on $5 per share – since the price increased from $10 to $15.
Do Stock Options Get Taxed Twice?
Another common question we get when it comes to taxing stock options is – do stock options get taxed twice? Yes – you now know that they do. You’ll pay ordinary income tax on the total amount you earn, and capital gains tax on the difference between your strike price and the market price at the time of exercising. But, as you’ll learn below, not all options are taxed twice. That’s why it’s important to learn the difference between NSOs and ISOs. Let’s take a look.
Incentive Stock Options vs Nonqualified Stock Options
Now, there are two types of stock options and the manner in which they are taxed differs. This is important to keep in mind particularly if you’re being offered company stock options.
- ISO – no tax liability for exercising the option. You pay capital gains tax when you sell your contract or sell the stocks in your option.
- NSO – you pay both ordinary income tax upon exercising the option and capital gains tax upon selling the contract/stocks.
As you can see, there are tax benefits to going with the ISO – you don’t pay any ordinary income tax at any point. You are just responsible for the capital gains tax upon selling. But, you also must meet certain holding periods to attain these benefits. You must hold onto your ISO for no less than a year after exercising the option, and two years after your options were granted.
How Do I Avoid Paying Taxes On Stock Options?
At this point, you’re probably wondering – how do I avoid paying taxes on stock options? As we mentioned earlier – only so much can be done. If you’re making money in the stock market, you’re going to pay taxes on that money. Uncle Sam wants his cut. However, you now know that your best bet is to stick with ISOs over NSOs to avoid paying ordinary income tax. You also must pay close attention to holding periods. Is there anything else that can be done though?
Our best advice is to chat with a qualified tax professional in your jurisdiction. Tax law varies from state to state. With that said, there are a few things you can do to lower your tax burden as it pertains to options:
- Move to a state with lower tax rates
- File an 83(i) election to defer taxes on NSO for up to 5 years
- File an 83(b) election after exercising options early
- Transfer your options into an IRA and use the income for long term wealth
- Exercise just enough options each year to avoid AMT (alternative minimum tax)
- Move capital gains income into an OZF (opportunity zone fund)
How Are Stock Options Taxed When Sold Or Exercised? Parting Thoughts
You now know just about everything you need to trade options in confidence from a tax perspective. We’ve said it before and we’ll say it again – seeking advice from a qualified tax professional in your state is still your best bet. After all – we’re not tax experts. We’re experts on actual stock trading.
And, if you want to earn the same returns as the expert traders you look up to – you need to use the same technology and tools they do. That includes a stock forecasting software like VectorVest. This software can help you simplify trading forever and make more informed decisions as to what to buy, when to buy it, and when to sell it. Start playing the game on easy mode today with a 30-day risk-free trial – you’ll never look back, trust us.