When exercising stock options there are typically two methods of doing so:
Exercise, sell the stock, and take the cash. This is usually done through a 'cashless exercise' where you do not have to use any cash up front. A proportionate amount of shares is deducted to cover taxes and fees and you net the proceeds.
Exercise them and hold the stock. This typically requires you to use personal cash up front, although some plans have alternative methods of doing this (buying on margin).
When deciding which method to use, you must first identify if you have qualified or nonqualified stock options. Qualified options are referred to as ISOs and have different tax implications than nonqualified stock options. We'll address each of these separately.
Qualified options should typically be exercised through an exercise-and-hold strategy. Unlike nonqualified options, if you exercise and hold the shares for a year, the gain portion of the exercise is taxed at lower capital gains rates. There are also Alternative Minimum Tax implications to qualified options. There are a few scenarios in which it may be best to sell an ISO immediately, but you should consult with a professional prior to doing so.
The value of nonqualified options is taxed at ordinary income rates at the time of exercise.
Regardless of the method of exercise, you will be taxed immediately. Choosing between an exercise-and-sell and exercise-and-hold strategy depends largely on the following factors:
Stock options have the potential to create significant wealth for many people. Whether or not you have qualified or nonqualified stock options, it is usually prudent to consult with a professional prior to making a decision on exercising options.