Exercising stock options this year: A tax-smart move?, MarketWatch.com, Oct. 9, 2012,

http://www.marketwatch.com/Story/story/print?guid=A65D1C92-1252-11E2-B403-002128049AD6

The so-called Bush tax cuts will automatically expire at year-end unless Congress takes action. Plus, the new 3.8% Medicare surtax on investment income collected by higher-income individuals is scheduled to take effect next year. The combined tax-hiking impact of the Bush cuts going away and the 3.8% Medicare surtax coming on line has been dubbed Taxmageddon.

Folks with significant in-the-money employer nonqualified stock options (NQSOs) need to understand that exercising this year, if possible, could be a tax-smart move -- because exercising next year could put you in Taxmageddon territory. Here's the scoop, starting with the basics on how NQSO exercises are taxed.

Nonqualified Stock Option (NQSO) Tax BasicsWhen you exercise an in-the-money NQSO, the bargain element (difference between the market value of the option shares at the time you exercise and the exercise price) counts as additional compensation income for tax purposes. Therefore, that bargain element can be hit with federal income tax plus withholding for Social Security and Medicare taxes. Depending on where you live, you may owe state income tax too.

Important Point : Don't confuse employer-granted NQSOs, which we are talking about here, with employer-granted incentive stock options (ISOs) which we are not talking about here. When you exercise an in-the-money ISO, you won't owe any regular federal income tax or any Social Security or Medicare taxes. However exercising an in-the-money ISO can cause an alternative minimum tax (AMT) hit in the year you exercise.

Impact of Expiring Bush Tax Cuts

Starting next year, the federal income tax rates on ordinary income, including income triggered by exercising in-the-money NQSOs, are scheduled to change for the worse. The existing 10% and 15% rate brackets will be replaced by a 15% bracket; the existing 25% rate will be replaced by a 28% rate; the existing 28% rate will be replaced by a 31% rate; and the existing 33% and 35% rates will go up to 36% and 39.6%. These existing and future ordinary income rates also apply to short-term capital gains from selling shares acquired by exercising an NQSO.

While the extra income triggered by exercising an NQSO next year would not itself count as investment income for purposes of the surtax, it would raise next year's MAGI, which could cause some or all of next year's investment income to be hit with the surtax. The important thing to understand is that nobody who exercises this year will be exposed to the surtax, while folks who exercise next year might be. (For details on the surtax, see " Prepare for the New Investment Tax ".)

Here's an Example

Say you're unmarried with a salary of $120,000 and $30,000 of annual investment income from capital gains, dividends and interest. You own an NQSO that allows you to buy 10,000 shares of employer stock at $30 a share.

Exercise This Year : Before year-end, you exercise the NQSO when the stock is trading at $45. The bargain element is $150,000 ($15 a share, multiplied by 10,000 shares), and that amount is taxed as additional 2012 compensation income. Based on this year's federal income tax brackets, a little over half of the $150,000 would probably be taxed at 28% and the rest at 33%, which would translate into a tax hit of about $45,500 (the exact result would depend on your precise tax situation). Since your salary exceeds this year's $110,100 ceiling for Social Security tax withholding, there won't be any extra withholding for that tax, but you will have about $2,200 of extra Medicare tax withholding. The combined federal tax hit from exercising would be about $47,700 ($45,500, plus $2,200).

Exercise Next Year : If you wait until next year to exercise, the tax results could be significantly worse. To keep things simple, let's say the company stock sits at $45 a share, and your salary and investment income stay the same. The $150,000 bargain element when you exercise the NQSO next year will be taxed as additional 2013 compensation income. Based on next year's projected federal tax brackets, about 55% of the $150,000 would probably be taxed at 31% and the rest at 36%, which would translate into a tax hit of about $49,800. Since your salary would exceed next year's projected ceiling for Social Security tax withholding, there would not be any extra withholding for that tax, but you would have about $2,200 of extra Medicare tax withholding. Finally, the extra income triggered by exercising the NQSO would cause all $30,000 of your investment income to get smacked by the new 3.8% Medicare surtax. That would add about another $1,100 to your federal tax bill for a total of about $53,100 ($49,800, plus $2,200, plus $1,100).

The Difference : In this example, the federal tax hit from exercising the NQSO next year would be about $5,400 higher than if you exercise this year ($53,100 versus $47,700). Ouch! If the numbers involved are bigger, the tax difference would probably be bigger too.

The Bottom Line

While waiting until next year to exercise an in-the-money NQSO will not always result in a higher tax price, the odds won't be in your favor unless Congress changes the 2013 tax rules and the president (whoever he is at the time) goes along. Also, if you put off exercising until next year and the company stock appreciates between now and then, the odds are even greater that you'll pay a bigger tax price -- because you'll have that much more compensation income to be taxed at potentially higher 2013 rates. All that said, it's still possible that Taxmageddon won't be allowed to happen: The Bush tax cuts could be extended, and the Medicare surtax could be repealed. Your best tax-smart strategy may not become clear until after we know the results of the November election. Stay tuned!