Pair NSO Exercises With ISO Exercises
Pairing NSO exercises with ISO exercises can help minimize (or eliminate) AMT tax exposure
Strategy Overview
When you exercise ISOs, the bargain element is considered income for AMT purposes (but not standard tax), potentially resulting in an AMT tax bill. Alternatively, for NSOs the bargain element is considered ordinary income and taxed as such. When your marginal tax rate for standard tax is in the 32% or higher tax bracket, an opportunity exists to pair the two together: exercised NSOs generate ordinary income at a tax rate higher than the AMT tax rate, increasing the amount of AMT income you can realize without triggering AMT taxes (and thus increasing the number of ISOs you can exercise without triggering AMT Tax).
Tax Details
AMT tax is a parallel tax to standard income taxes, and each year you pay the higher of the two tax calculations. In most cases, your regular income tax bill/calculation is higher than the AMT calculation due to AMT exemption, so you pay the calculated standard income tax amount (click for more information on AMT)
Due to the different applicable tax rates of (i) standard tax, and (ii) AMT tax -- when you realize ordinary income in the 32% or higher standard tax bracket, that should widen the gap between your standard and AMT tax calculations. With that in mind, if you have both NSOs and ISOs, one strategy is to exercise NSOs, increasing the gap between your standard and AMT tax calculation, allowing you to exercise a larger number of ISOs without triggering AMT tax.
This strategy is complex and typically requires robust tax calculations/forecasts by a professional to execute. But the benefits of reducing/eliminating an AMT tax bill can be worth it.
This strategy only works if your marginal income tax bracket is the 32; 35; or 37% bracket. If your marginal tax bracket is 24% or lower, the gap between standard and AMT tax could actually shrink when you realize additional income from NSO exercises.
Key Benefits
Optimize your total tax bill. Strategically exercising NSOs and ISOs together allows you to optimize overall taxes owed, especially considering you are likely to exercise both at some point anyway.
Reduce or eliminate AMT liability. Exercising NSOs to increase regular income tax can reduce the amount of AMT triggered/due (if any) from exercising ISOs in the same year.
Key Considerations/Flags
Potential for higher taxes. Your income tax bill will be higher with this strategy (because you exercised NSOs, which increased your income). Assuming you planned to exercise anyway, pairing your NSO exercise with a strategic amount of ISO exercised will likely help you reduce or avoid AMT taxes on top of that. But your income tax bill will be larger than if you had not exercised any NSOs.
Requires precise tax calculations/forecasts. AMT is complex, and free lightweight tax analysis tools will likely provide poor, or even incorrect, guidance (we've seen many try; the results are discouraging). To implement this strategy with any precision, a robust tax forecast done by a professional is likely required.
Harder to implement. Exercising both NSOs and ISOs in a precise, tax-optimized way, make this strategy somewhat more difficult to implement.
Strategy: When to Consider This and When to Avoid It
🟢 When to Consider This Strategy:
You have already exercised or plan to exercise a significant number of ISOs. This likely triggers a high AMT liability.
You have vested NSOs available to exercise. Exercising these can generate additional ordinary income to help offset the ISO AMT impact.
Income tax rates are favorable for exercising this year, and you don't anticipate lower marginal tax rates in future years.
🔴 When to Not Use This Strategy:
If your marginal tax bracket is 24% or below, this strategy will not work. AMT tax is assessed at either 26% or 28%. To make the gap between your standard tax and AMT tax widen, your marginal tax bracket (e.g. the tax rate you'd be assessed on the next dollar you earn) needs to be in the 32% bracket or higher.
If you otherwise wouldn't plan on exercising your NSOs. Exercising NSOs is foremost an investment decision. If you haven't already decided to exercise (i.e., a question of "when", not "if"), then the tax benefits aren't worth the investment risk.
If valuations are uncertain or anticipated to be volatile and that makes you uncomfortable. Fluctuating stock prices increase the risk of loss and unintended tax consequences.
You anticipate lower income tax rates in future years. Paying 37% income tax on NSOs exercises this year to reduce or avoid AMT tax isn't likely worth it if your income will drop materially in the next 1-2 years, where NSO exercises would be taxed at 22% to 32%
Example
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