Editor’s note: Interested in learning more about equity compensation, the best time to exercise options, and the right company stock selling strategies? Read our Guide to Equity & IPOs

Many young executives worry about triggering taxes by exercising options. But, as Kent Williams, founding partner at Mohler, Nixon & Williams, and other tax experts will tell you, you could be passing up huge tax savings if you don’t purchase at least some of your shares now.

Exercising options means you might have to pay income taxes up front, and possibly the Alternative Minimum Tax (AMT) on top of regular income taxes.

That tax falls on the difference between the strike price and the value of the shares, usually determined by the board of directors of your company.  But that AMT can become a credit against the capital gains tax that you would have to pay when you sell your stock.

If you do it right you can save as much as 20% of your gain by paying lower capital gains taxes when you sell, says Mr. Williams.

The caveat here, of course, is that you need enough money to pay the taxes that will be triggered by your options exercise. (You may choose to exercise some and not all of them). You’ll also need a reasonable amount of confidence in your company’s future: Don’t incur the tax hit unless you think it’s highly likely the shares will be worth more in the future.

Tax paralysis

Thinking about the taxes on your options this way – as an investment in the future – is one way to overcome what expert’s term “tax paralysis.”

During the tech bubble, IPO employees often suffered from tax paralysis, says Lynn Ballou, a managing partner at Lafayette, Calif.-based Ballou Plum Wealth Advisors, LLC.

“That was the huge lesson we learned,” she says. “It can be hard to fathom why you’d be willing to lose a third of your value to taxes. But people shouldn’t be afraid of paying the taxman if it means locking in some real value.”

Ms. Ballou described a client who worked for a “Cisco-like” firm, and who was worth $30 million on paper at a very young age. Confronted with the tax bill associated with cashing out, he decided to let his stock ride, and wound up worth less than $500,000 when all was said and done.

Historic lows

There is even less reason for a young executive now to worry about taxes, because rates are at historic lows.

Mary Kay A. Foss, a director at Sweeney Kovar, LLP, a Danville, Calif.-based CPA firm, pointed out that both kinds of taxes – ordinary tax rates and long-term capital gains tax rates —  that are of concern to employees at companies that offer options packages are at low rates. (The AMT rate of 28% has long been unchanged).

Thanks to the so-called Bush tax cuts enacted in 2003, a married couple filing jointly and earning more than $379,150 in 2011 paid taxes at 35 percent; earning between $212,300 and $379,150 paid at 33 percent; and earning between $139,350 and $212,300 paid at 28 percent. (See this chart from the Tax Foundation for a year-by-year list of nominal and inflation-adjusted tax rates and brackets.)

The long-term capital gains tax, which comes into play when you sell stock that you’ve held for more than a year for a gain, is also at a historic low of 15%.

It’s worth noting, especially if you are exercising options or selling stock this year, that those lows may not last. Tax rates are scheduled to rise in 2013 when the Bush-era tax cuts expire, unless Washington acts to prevent the increase. That’s highly unlikely in an election year.

— Patrick Clark contributed to this post

Wealthfront does not provide individual tax advice, and you should consult your tax advisor regarding any questions you may have specific to your personal taxes and financial situation.

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About the author(s)

Journalist Elizabeth MacBride is Wealthfront's editor. Her work has appeared in Crain's New York, Advertising Age, the Washington Post and the Christian Science Monitor, among other publications. View all posts by Elizabeth MacBride