When most people think of employee benefits, they think of health insurance, 401(k)s, and maybe some free food. But for folks at the top of their fields, benefits may include stock options. If you’ve got a job that comes with incentive stock options (ISOs), it’s important to know how those options work and what they can do for you. For one thing, they come with favorable income tax treatment. But let’s not get ahead of ourselves. Read on for our guide to ISOs.

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Incentive Stock Options: The Basics

Incentive stock options are perks given to certain employees as part of their hiring package. ISOs give employees the “option” to buy company shares at a pre-determined price known as the grant price. ISOs have a big tax advantage. If employees exercise their options after the price of the company stock has risen, there is no tax on the difference between the value of the stock and the price an employee pays for it. In fact, you don’t have to report an ISO as income, either when you receive the options or when you exercise them.

And there’s more: If you exercise your options, hold the shares for at least one year after purchase and two years after being granted the options, when you sell those shares the profit is taxed as long-term capital gain. Because the tax rate on long-term capital gains is lower than the income tax rate, you’ll come out ahead.

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ISOs and the AMT

So we know there’s an income tax advantage to ISOs. But before you get too excited about your low taxes, remember the Alternative Minimum Tax (AMT). The AMT is designed to capture some income taxes from folks who have a lot of tax-free income. ISOs can trigger payment of the AMT, so it’s important to make sure you’re doing your taxes carefully for each year you hold ISOs. The bargain element of an ISO is the difference between the price you pay for the stock and its market value. You must report the bargain element as an income adjustment for AMT purposes when you purchase the stock. Later, when you sell the shares, you may have to pay the AMT.

Vesting

ISOs are often subject to a vesting schedule. An employee who is higher up on the corporate ladder may be offered ISOs that only vest after a certain number of years, or that vest partially year by year. Because ISOs are used to attract and retain valuable employees, employers don’t want their new hires to take them and run. Hence the vesting schedule. In some cases, companies may “claw back” ISOs if they become unaffordable.

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ISOs vs. Non-Qualified Stock Options

ISOs are also known as Qualified Stock Options. That’s to distinguish them from what are known as Non-Qualified Stock Options. So what’s the difference? For one thing, ISOs come with more favorable tax treatment than non-qualified stock options. Non-qualified stock options don’t “qualify” for the same income tax break that ISOs enjoy. They don’t come with that bargain element that makes ISOs so attractive.

Instead, employees must report as regular income the difference between the price they pay for company shares (the grant price) and the market value for those shares. Non-qualified stock options are easier for employers to administer. Plus, employers can deduct the cost as a business expense. Not surprisingly, non-qualified stock options are more common than ISOs.

Bottom Line

If you’re offered options as part of your employee benefits package, that can be cause for celebration. It’s a good idea to take the time to sit down with your employer or your company’s HR department to make sure you understand the specifics of the options offer. And remember that ISOs are not a guaranteed financial home run. First, you must make the initial investment of purchasing the shares. Then, you’ll have to hold those shares long enough to qualify for the long-term capital gains rate. There’s no guarantee that you’ll make a profit at the end of that holding period.

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