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If you have Incentive Stock Options (ISOs), then you also have to think about the Alternative Minimum Tax (AMT). Otherwise, you may be in for a surprise when you file your taxes!
Before we get too far into this, it's important to understand the basics around incentive stock options and the way they're taxed. I did a previous video that talks about that so it would be helpful to watch this one first:
Once you've watched that one, then I would encourage you to then come back to this one:
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There's one final thing that's really important, and it's called the AMT credit. In this scenario, whenever you've exercised stock options, and it's caused you to have AMT, this amount can get used as the AMT credit.
Generally, the way that the AMT credit works is that in future years, whenever you're not exercising ISOs, you're still doing these two calculations. In the years that your regular tax is higher than your AMT, your alternative minimum tentative tax, then you can actually use some of this credit to lower your next year's income.
Now it's not as super straightforward as just saying, "Okay, you can just take that $5,000 and get it all back the next year." So it's possible that it takes multiple years to get that credit back. But the nice thing is that this credit never expires, and so you're able to carry it forward indefinitely until you use it all up.
I think the best way to explain AMT and the way that it works is to first walk through the way that your regular tax calculation works.
The final number that you get is called your total tax, and that's just how much you owe in taxes.
So with this regular system, what was happening is that there were certain scenarios where people were actually making a lot of money but were able to use this system in a way where they actually didn't have to pay a whole lot in taxes. So in the '60s, the government said, "Hey, we need to figure out a way to close these loopholes." So what they did was they created a whole parallel tax system, and they called that the alternative minimum tax.
Now let's do a real quick version of how the alternative minimum tax works.
Let's walk through this with our example. Let's say that in the regular tax system that whenever we go through this that we get to here, and then our tentative tax is $30,000. But since we exercise some ISOs and we've carried them over through the year, then that bargain element gets added here. So we'll just say in our same example that we run through this parallel calculation, and then our tentative tax here comes out to $35,000. Whenever this happens, then you pay whichever one is the higher one. In this scenario, you would pay the $35,000 dollars, and the way that they would do that is they would just add another five thousand dollars underneath the tentative tax here, and that would be your $5,000 of AMT.
Now let's talk about some of the planning opportunities with this.
The first one is if you know that you're going to be exercising ISOs, then you want to know what this number is going to be because otherwise, you could get really surprised by the amount of AMT that you would expect to owe, and you don't want to be caught off guard with that. You'll probably need a tax professional or a financial professional that understands this information to be able to help you with that, but it's good to know that just so that you're not caught off guard.
Then the second planning opportunity is there's actually a way that you can exercise stock options without having to pay any AMT. So let's break this down real quick. Every year you're actually doing both of these calculations; you just might not know it. But in a normal year, whenever you don't have any of these kinds of special things here, then this tentative tax on your normal taxes is higher than your AMT tentative tax.
So let's just say in our example that we have $30,000 on your normal taxes, and then the AMT tentative tax without any of these adjustments is $20,000. Well, what that's saying is that you can actually start exercising some amount of ISOs, and you can increase the AMT tentative tax but make sure that it doesn't go over the normal tentative taxes. That way, you can actually do an exercise without paying any sort of AMT.
What we're talking about here with AMT, it's about exercising your options and the bargain element. So I'll do a quick explanation of what that is.
If we walk through an example kind of similar to what I did in the last video, assume that we have been granted 1,000 ISOs, and it has a $10 strike price or exercise price. Then, whenever you actually exercise it, you take the difference between the price, the strike price, and the actual value of it that day that you exercise it. So in our example, we have $50, and the strike price is $10, so then the difference between those two is $40 per share. You multiply that by the 1,000 ISOs that we just turned into stock, and that gives us $40,000 dollars. That is called the bargain element.
In the last video, I talked about how if you exercise here and then you wait more than a year before you sell it, then there are some tax benefits to that. With the bargain element here, the reason why I'm pointing it out is that if you exercise in a year, but then you don't sell within that same calendar year, then this bargain element gets plugged into the alternative minimum tax calculation.