rewrite this title The Employee’s Guide to IPO Tax Planning: How to Manage Your ‘Enormous Income Year’ – NerdWallet

Three types of equity are commonly held by employees at pre-IPO companies: restricted stock units (RSUs), incentive stock options (ISOs) and non-qualified stock options (NSOs). Each has its own tax rules and strategies. When you hold more than one type, or even all three — which is true of many employees at companies like Anthropic and SpaceX — the tax implications become even more complex.

Read each of the sections below that correspond with the type of equity you own. If you hold more than one type, read the section on mixed equity to understand how they interact.

With RSUs, the main tax event occurs at vesting, which could be on IPO day. Some RSUs vest on a predetermined timeline, but others may be double-trigger RSUs, which vest only after another event takes place, such as an IPO. It’s possible for employees at pre-IPO companies to hold both, says Aaron Brickley, a certified financial planner and certified private wealth advisor with Brickley Wealth Management in San Mateo, California.

The second trigger can be an advantage because it ensures you aren’t paying taxes on private company stock you can’t sell. But it means all your RSUs will vest at once, and the value of those shares is treated as income. “You may have an enormous income year in the year of an IPO,” Brickley says. “So what sort of planning do you maybe do for that?”

There are multiple steps you could take to reduce your tax liability or otherwise make the most of a high-income year, Brickley says. For example, you may ramp up retirement contributions, set up a donor-advised fund to get a charitable tax deduction or exercise additional stock options (more on this later). The right set of strategies during the year of the IPO also requires keeping in mind your broader financial plan.

Employers often withhold taxes on RSUs at the time they vest. You may be able to elect to “sell to cover,” which allows you to automatically sell a portion of your newly vested shares for tax withholding. But make sure you’re withholding enough to cover your tax liability, or plan to make estimated quarterly tax payments.

The IRS default tax withholding rate is 22%. (Though any supplemental income above $1 million is withheld at 37%.) If your tax bracket is higher than 22%, the default rate won’t withhold enough to cover what you actually owe. To avoid a surprise tax bill, calculate what you’ll owe in taxes during the year your RSUs vest. If the withholding rate is too low, you’ll need to make changes before the RSUs vest. Your company’s HR department or equity platform can walk you through those steps.

Beware of overcorrecting, though, Brickley says. If you overwithhold on RSUs, it could mean you sold more shares than necessary to cover taxes, missing out on further gains you would have realized if you’d held the shares. The right withholding rate will depend on your full financial picture. You’ll need to take into account any additional income and deductions, as well as state taxes.

You may owe capital gains tax on any shares that appreciate before you sell them. The tax rate will depend on how long you held the stock.

However, you may owe alternative minimum tax (AMT). More on that below.

When you choose to sell your shares, ISOs may be subject to the lower long-term capital gains tax rate (instead of your ordinary income tax rate) if you meet certain holding requirements. Two things must be true:

If you don’t meet the holding requirement, the bargain element is taxed as ordinary income, and you may owe capital gains tax on any appreciation.

At tax time, you calculate your tax liability under each of the systems, and you pay whichever is highest. What’s tricky about this is you haven’t yet sold your shares. So you may owe taxes on income you haven’t fully realized yet. If you exercise options and pay AMT, and then the price of your shares goes down before you sell, you may have overpaid taxes.

There are strategies to use if you want to avoid AMT. For example, you may decide to limit the number of ISOs you exercise so that AMT doesn’t exceed your ordinary income tax liability, says Steve Moyer, a certified financial planner and certified equity professional with Mariner, a wealth management firm. “What I always talk to people about is at least exercising up to the equilibrium point — the point where regular tax equals AMT,” he says. “We don’t always want to go into AMT, but we want to push at least up to that point every single year.”

It’s not always possible to avoid AMT, though. The key is to avoid being surprised by it. If you know you may owe AMT, you’ll need to plan for the tax bill. “That’s actually a good thing because it means the options have grown quite significantly,” Moyer says.

NSOs are stock options that don’t get the same favorable tax treatment of ISOs. It’s common for startup employees to accumulate both types of options if they’ve been at a growing, pre-IPO company for a few years. Here’s why:

NSOs are taxable when you exercise. At that time, the bargain element (FMV minus your strike price) is treated as ordinary income. When you sell, you may owe short- or long-term capital gains on any appreciation above the FMV on the date you exercised.

ISOs, NSOs and RSUs may have differing mechanics but they all show up on the same tax return. The interaction creates at least two surprising possibilities.

During an IPO, double-trigger RSUs may vest and are treated as ordinary income. Similarly, any NSOs you exercise also get tallied in your W-2. “We saw this with SpaceX,” says Moyer, whose clients include employees at the company. “A lot of people had larger grants and the price went up quite significantly. So they might have several million dollars of RSU income this year.”

That can be a reason to exercise even more shares — as long as they’re ISOs. That’s because the difference in the highest tax rates between the ordinary income tax system and AMT naturally leaves room to exercise ISOs without triggering AMT. Moyer calls it the AMT cushion. The higher your ordinary income is in a given tax year, the larger your AMT cushion is, and the more ISOs you can exercise and hold — starting the clock on the one-year holding period required to get favorable tax treatment — without owing AMT.

Alternatively, if you exercise so many ISOs that you’ve essentially guaranteed you’ll have an AMT bill, any ordinary income you earn that year — from NSOs, RSUs or other sources — is taxed at the AMT rate. The highest is 28%, compared to 37% in the ordinary tax system.

In that case, it can be strategic to maximize your ordinary income, knowing you’ll pay a lower tax rate. For example, someone who holds NSOs might exercise and sell those, so they can hold their exercised ISOs until they’ve met holding requirements, Moyer says. “They can exercise millions of dollars of NSO income and only be taxed at 28%.”