Incentive Stock Options (ISOs): A Comprehensive Overview

Incentive stock options, or ISO's, are a type of benefit that many companies offer their employees. This type of stock option program provides employees with tax advantages and several benefits. Incentive stock options are a type of stock option that are reserved only for employees of the company. In most cases, they are reserved for upper-level executives in the company.

What is it?

An ISO is essentially a contract that is offered to the executive as a way to allow them to purchase a certain amount of shares of stock at a certain point. The executive can exercise the contract and purchase these shares at a specified price regardless of what is going on in the market. Individuals can sometimes take a substantial profit from the market.

Tax Benefits

Incentive stock options vary from traditional stock options because they allow individuals to take advantage of a nice tax benefit. With other types of stock options, you have to pay income tax on the amount of money that you make from the transaction. However, with incentive stock options, you will not have to pay tax at the regular marginal tax rate if you handle it correctly.

With incentive stock options, you can get out of paying income tax and instead pay capital gains taxes on the amount. If you were in the highest tax bracket, as many company executives are, this could potentially save you 20 percent in taxes. The highest tax bracket is 35 percent while long-term capital gains are taxed at 15 percent. In order to take advantage of this tax benefit, you have to hold the shares for least one year after they are issued. You also have to wait two years from the date of grant of the shares in order to take advantage of the tax benefit.

Risks

Even though this type of stock option can be beneficial, there are some risks. To begin with, since you have to hold the stock for an extended period of time, you could take some serious losses. For example, if you exercise the stock and then over the next year, the company declines rapidly in value, you could lose a significant amount of money in the stock market. Having to hold stocks for an extended period of time exposes you to additional risk. Because of this, many people end up selling the stock quickly and simply paying the extra tax on the difference.

Some investors prefer to lock in profits right away instead of speculating on the price of the stock over the course of the next year. As an investor, you have to decide whether you want to gamble on the price of the stock or if you want to go ahead and sell it. This can be a tough decision depending on the strength of the company that you work for.