The concept of income taxes probably hit home the day you saw your very first paystub. You worked 10 hours at your summer job for $15 per hour, but instead of getting a paycheck for $150, the amount was only $120. What happened? Income taxes: Your employer withheld the taxes on your income levied by federal, state and local authorities. 

By now, we’ve (hopefully) all gotten used to the idea that income such as wages, salaries and bonuses are taxed. If you’re a startup employee with stock options, you might be hearing about a different kind of income tax, known as capital gains tax. Here are a few key things to know about how capital gains taxes work and how they could impact your decision about when to exercise your options. 

What are capital gains taxes?

From a tax perspective, nearly everything you own and use for personal investment purposes is considered a capital asset. This includes stocks, bonds and mutual funds as well as your home and car. 

When you sell a capital asset for more than you spent to buy it, you’ve created a capital gain. The federal government and many states have specific tax systems for the income generated by capital gains. 

Let’s look at a simplified scenario. Say you exercised 100 options at a strike price of $1 each, totaling $100. Later, you sell the shares for $5 each, equaling $500. Upon sale, you will have “realized” a capital gain of $400, calculated as $500 minus $100. You’ll likely have to pay taxes on that capital gain of $400, which means your ultimate profit would be less than $400.

In the U.S., your capital gain tax liability is determined by how much you spent to buy the asset (your cost basis) and the sale price. 

In the case of stocks, the share price will fluctuate throughout your ownership period, but those daily moves don’t matter for capital gains — just the purchase and sale prices.

What’s the difference between short-term and long-term capital gains tax? 

Capital gains are classified as long-term or short-term, based on the time between purchase and sale (your holding period). Generally, if you held the shares for more than one year before you sold them, your capital gain is categorized as a long-term capital gain. If you held the shares for one year or less, your capital gain is short-term. 

Why does it matter? Tax rates on long-term gains are often significantly lower than the rates applied to short-term gains.

Federal long-term capital gains taxes generally range from 0-20%. Short-term capital gains are usually taxed according to your income bracket, which means the IRS can tax your short-term capital gains at the same rate it taxes your income (i.e., wages and salary). These rates can be as high as 37%. 

On a state level, things vary widely. A few states, like Florida and Texas, don’t have capital gains taxes for individuals. Other states offer credits or certain tax breaks for capital gains. In California, capital gains are taxed as ordinary income; there’s no designation (or benefit) between long-term or short-term.

What if you sell your shares for less than you bought it for?

So far, we’ve focused on a scenario where you sell your shares for more than you paid to buy them, creating a capital gain. Of course, it’s also possible to sell your shares for less than you paid, which creates a capital loss. 

While it’s not exactly pleasant to lose money on an investment, a capital loss may help you from a tax perspective. Capital losses can be netted against capital gains in a given tax year. 

In simplified terms, this means it’s possible for some losses to cancel out some gains; you only pay taxes on any net gain. Your tax professional and/or financial advisor can provide more guidance on this topic.

If you have capital gains, you may have to make estimated payments throughout the year to the IRS.

How do capital gains taxes affect stock options and when I should exercise?

When you exercise your vested stock options, your company delivers shares to you and your holding period officially begins. The clock starts ticking toward long-term capital gains tax rates. 

If you hold shares for a year or longer before selling them, the money you make is taxed at the long-term capital gains rates. Otherwise, it's taxed at ordinary income rates, which is a higher tax rate.

The difference can be quite significant. For example, if you live in California the highest ordinary income rate can be more than 52%. But the highest capital gain rate is about 37%. That’s 15% you’re losing to taxes if you don’t hold for at least a year. 

What does this mean if your company is on the path to an IPO or other exit scenario? An exit often represents your first chance to sell your shares and unlock their value. If you exercised your options early enough, you could have your tax discount already teed up when the first opportunity to sell arises — typically after a lockup period ends.

You can see real-world examples of how these factors came together for employees at Snowflake and DoorDash.

Lastly, it’s important to note that you probably will incur taxes when you exercise your options. These taxes are separate from any capital gains taxes due when you sell your shares.

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