Your source for data-driven advice on investing and personal finance. See how Wealthfront can help you reach your financial goals. O ne of the most valuable terms in your option agreement is the ability to exercise your options before they have vested. The ability to exercise early allows you to change the gain on all your options from ordinary income to a long-term capital gain, which is taxed at a much lower rate. Section 83 of the Internal Revenue Code states that you do not have to recognize income from owning equity in a company until that stock vests. Section 83 b refers to a special election you can make with the IRS to let them know that, despite the fact you have not yet vested your stock, you still want to recognize the income associated with ownership immediately. In the past 83 b elections were a niche issue that largely applied only to founders of companies. Unlike most employees, founders are issued their shares for a fraction of a cent rather than in the options of an option. Much of the time, when a founding team raises venture capital the terms of that investment include a requirement for the founders to vest their shares over four years. It may sound strange that founders, who own the company, voluntarily agree to a vesting schedule, but investors require it to provide an incentive for the founders to stick around through the likely term of the venture capital investment. Founders that are in the know would file their 83 b election before they raise money i. As competition for outstanding employees has grown over the past decade, many companies began to offer their employees who were issued stock options the ability to exercise their options early so they could potentially benefit from more favorable tax treatment. Most stock options stock technology companies vest over four years, with a one year cliff. Early exercise allows you to exercise that option before you have vested your stock. You may be wondering why you would pay for your stock before it has vested. After all, options have value. The right to buy stock at a fixed price for an extended period of time is potentially very valuable, partially because you do not need to come up with the money for the stock immediately and you can choose to exercise any time. The United States rewards individuals who hold their investments for more than one year with discounted taxes. These long term capital gains tax rates are based on when you first acquired your stock. The maximum marginal federal ordinary income tax rate of That value, by the way, is typically at a significant discount to the price venture capitalists and other investors have paid for their preferred shares, which have additional rights. This creates a significant reward for the employees who are willing to take the risk of joining an early stage company. When you exercise your stock option, you pay the exercise price of the option for each share. The IRS considers the difference between the current fair market value and your exercise price as income in the current calendar year, either as ordinary income for a Non-qualified Stock Option or as an AMT preference item for Incentive Stock Options. We explained this scenario in detail in Three Ways To Avoid Tax Problems When You Exercise Options. If you exercise your stock options early, you buy the stock from your employer. In practice, this means that every time you vest additional stock from your exercised stock options at the one year cliff, and every month afterwardthe IRS expects you to declare income based on the difference between the exercise price and the value of that stock on that date. The 83 b election resolves this issue, elegantly and simply. This is why, by the way, you only need to file the 83 b when you exercise stock options that you have not vested yet. Thus, if you exercise your stock options when the fair market value equals the exercise price, the 83 b leaves you with no tax liability until you actually sell your shares. The decision of whether or not to early-exercise your stock options is a complicated one, and may not make sense in some situations. However, if you do decide to early exercise, just remember: Always File Your 83 b! This article is not intended as tax advice, and Wealthfront does not represent in any manner that the outcomes described herein will result in any particular tax consequence. Prospective investors should confer with their personal tax advisors regarding the tax consequences based on their particular circumstances. Wealthfront assumes no responsibility for the tax consequences to any investor of any transaction. Adam Nash, Wealthfront's CEO, is a proven advocate for development of products that go beyond utility to delight customers. Adam joined Wealthfront as COO after a stint at Greylock Partners as an Executive-in-Residence. Prior to Greylock, he was VP of Product Management at LinkedIn, where he built the teams responsible for core product, user experience, platform and mobile. Adam has held a number of leadership roles at eBay, including Director of eBay Express, as well as strategic and technical roles at Atlas Venture, Preview Systems and Apple. Adam holds an MBA from Harvard Business School and BS and MS degrees in Computer Science from Stanford University. Many young executives worry about triggering taxes by stock options. But, as Kent Williams, founding…. Vanguard versus Wealthfront — how do the two compare? In this post, we compare the two services and explain the relative advantages of Wealthfront. Path helps you prepare for your financial future, every step of the way. Please read important legal disclosures about this blog. This blog is powered by Wealthfront. The information contained in this blog is provided for general informational purposes, and should not be construed as investment options. These contributors may include Stock employees, other financial advisors, third-party authors who are paid a fee by Wealthfront, or other parties. Unless otherwise noted, the content of such posts does not necessarily represent the actual views or opinions of Wealthfront or any of its officers, directors, or employees. Wealthfront Knowledge Center Your source for data-driven advice on investing and personal finance. You must file your 83 b within 30 days of your early exercise. Tags career advicecareer planningemployee compensationIRSstock optionstaxesvesting. About the author Adam Nash, Wealthfront's CEO, is a proven advocate for development of products that go beyond utility to delight customers. View all posts by Adam Nash Questions? Explore our Help Center or email knowledgecenter wealthfront. Avatars by Sterling Adventures. 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Other members of the society also gain through externalities (Pradhan and Subramanian, 1999).