Exercise ISOs up to (But Not Above) the AMT Tax Limit
Exercising ISOs up to your AMT limit allows you to optimize for ISO preferential tax treatment without triggering/having to pay AMT
Strategy Overview
ISOs can provide valuable tax benefits, but exercising them can also trigger AMT. Before exercising ISOs, one can model out the tax implications of exercising various ISO amounts. Using that data, one can exercise a specific number of ISOs to take them up to (but not above) the point where they would owe AMT. Doing so allows one to setup their ISOs for preferential tax treatment (long-term capital gains vs. ordinary income tax rates) without triggering/having to pay AMT when the ISOs are exercised.
Tax Details
Standard and AMT tax are parallel tax systems; both are calculated each year and you owe the higher of the two. In current times, the AMT calculation has a large exemption, typically resulting in a household's standard tax calculation being greater than their AMT calculation.
However, exercising ISOs has unique tax treatment. When your ISOs have a bargain element, exercising ISOs will create income for AMT purposes, but not for standard tax purposes. Exercise a large enough amount, and you will owe AMT. But, conversely, the difference between standard and AMT calculations also provides a "free window" opportunity: exercise a strategically calculated number of ISOs to generate AMT income--but only an amount that makes your standard and AMT tax calculations approximately the same (and thus not resulting in AMT being triggered/owed).
Strategically exercising ISOs across years. The AMT exemption amount works on a per-tax year basis and any unused exemption does not carry forward. This dynamic means that the strategy is available every year. And, if one has a large number of ISOs a multi-year exercise plan could make sense. The goal would be to fully utilize the standard tax vs. AMT spread each year, but not exceed it (and thus not trigger any AMT).
This strategy will likely not work if you've paid AMT in the past. If you have an AMT credit with the IRS (due to paying AMT in the past), then a "free window" doesn't exist:
If you don't have an AMT credit, there is nothing to recoup, and the (standard - AMT) window is "free" and can be used.
If you have an AMT credit, there are funds you could recoup -- and any AMT income generated from exercised ISOs will reduce the amount of your AMT credit that you can recoup that year.
Note: Determining the optimal ISO exercise amount requires forecasting AMT tax thresholds each year based on your specific tax situation (and we strongly suggest you work with a professional to do this).
Key Benefits
Allows using the "free window" to exercise ISOs without triggering AMT. ISOs have preferential tax treatment, but taking advantage of that can result in unwelcomed AMT bills. Using your annual "free window" can help to avoid that.
Can be utilized over multiple years. The AMT exemption is per tax year, and unused exemptions do not carry forward. If exercising all your ISOs would likely trigger AMT in a given year, you can reduce AMT (or possibly avoid altogether) by spreading your ISO exercises over multiple years.
Key Considerations/Flags
Implementing this strategy likely requires tax forecasting done by a tax professional.
The benefits of this strategy can be diminished (or fully negated) if you have significant AMT credits (likely from prior ISO exercises). Careful planning is encouraged/required.
AMT liability must stay under or equal to regular income tax liability in order to not trigger incremental AMT. Again, careful planning is encouraged/required.
Strategy: When to Consider This and When to Avoid It
When you have in-the-money ISOs you would like to exercise and you don't have an AMT credit/haven't paid AMT in the past (i.e. you have a "free window" between your standard income tax and projected AMT).
If you otherwise wouldn't plan on exercising your ISOs. Exercising ISOs is foremost an investment decision. If you haven't already decided to exercise, then the tax benefits aren't worth the investment risk.
If you already have sizable AMT credits (likely from previous ISO exercises). AMT credits are subject to recoup each year. Any AMT income generated from exercised ISOs will reduce/eliminate the amount of AMT credit you can recoup that year.
If you don't have a reasonable understanding of AMT and don't have (or want to pay) a professional for help. Modeling AMT is complex and depends on your unique situation. If it's done incorrectly, you have risk in both directions: (i) underestimating the "free window" and not utilizing it fully, and (ii) overestimating the "free window", resulting in AMT being due.
Example
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