There can be significant tax benefits to exercising stock options before they vest. But if you are exercising early, you’ll need to file an 83(b) election with the IRS to make it official.
An 83(b) election is a one-page document that lets the IRS know you’re going to exercise early and accelerates the tax treatment of those options, allowing you to pay taxes on the current value of your as-yet-unvested shares, rather than their value once they fully vest.
Essentially, you’re agreeing to pay your taxes early based on your belief that when your options vest they will be worth more, or that tax rates will be higher. You need to file an 83(b) within 30 days of exercising your options, or you run the risk of the IRS not treating the stock options as exercised early.
Filing an 83(b)
The process of filing an 83(b) election is relatively straightforward:
- Step 1: Download an 83(b) form. Your company likely gave you one along with your offer documents. If not, ask your company’s finance team if they have a template you can use. Alternatively, stock option administration platforms, like Carta or Shareworks, offer 83(b) templates when you exercise early.
- Step 2: Fill out the form with information about the stock options you want to exercise.
- Step 3: Send the form to the IRS and give a copy to your company within 30 days of exercising your stock options. For your records, include an additional copy of the form, a postage-paid return envelope, and a letter stating that you want the copy to be date stamped upon receipt.
The benefits of exercising early
Not all companies allow employees to exercise their options early. However, if your employer does, there can be significant tax savings to going this route, especially if your strike price and the company’s fair market value (FMV) valuation is still relatively close.
Exercising early means you’ll pay income taxes on the current market value of the stock. You’ll also start the clock toward long-term capital gains tax rates — which you’ll qualify for if you hold the shares for at least one year after exercising (in the case of both non-qualified stock options and incentive stock options), and at least two years after they were originally granted (in the case of incentive stock options).
The drawbacks of exercising early
It’s important to understand the risks involved with exercising your options early. If the company declines in value, you could fail to recoup your investment. In addition, if you decide to leave your job before all of your early-exercised shares vest, many companies reserve the right to “claw back” any unvested shares you exercised early, buying them back from you at their strike price.
Understanding the costs
While exercising early can reduce your taxes in the long-term, you’ll still face upfront expenses, including the cost of exercising and any potential associated taxes.
Not sure how much exercising early could cost you? Our Stock Option Tax Calculator breaks down how much you would owe in taxes if you exercised now — and how that amount could change over time.