Maximizing your earnings from stock options
Disclaimer: I'm not a tax lawyer, accountant, or otherwise qualified to give reliable tax advice. This is not meant to be a comprehensive primer on what stock options are or how they work; there's plenty of information available elsewhere. If you choose to act on anything I describe here, confirm with a proper tax adviser that what I say is correct, up to date, and makes sense for your personal situation.
When you begin working at a startup, you may be given a grant of stock options. You need to know what they're worth. You actually need to know this before you accept the offer. It's part of your compensation, after all. I'm not going to try to describe how to do that right now; it's involved, even in brief form, and fraught with ambiguity. I'm also not going to explain what stock options are; there's tons of information already out there, and I strongly urge you to research it. Don't just stick that options grant paperwork into a drawer somewhere and forget about; it may cost you dearly.
The very first thing you need to do is to stockpile some cash. You need to have the cash necessary to exercise your options at will. News may come without warning, and you want to have the ability to take advantage of it. You also need some extra cash to deal with tax liability (see below). Lacking this cash on hand will force you into strategies that fail to maximize your return.
Let's just suppose that you know what the shares are worth, and you have some reasonable expectation of what they'll be worth a few years down the road. If you're not confident that the shares will be worth several times your strike price, sit tight and do nothing. However, if you are confident that they are worth 2-3 times your strike price, it's time to start doing something.
The multiple at which you do something is related to how soon you're likely to be able to liquidate. If you think the shares are worth 50% more than your strike price, and your employer is having an IPO in 2 months, you want to do something right away. If it's only 2x your strike price, and any kind of liquidity event is likely years away, you may want to hold off. You want to do this to build in some protection against misfortune, and also because your tax liability isn't likely to be that great with just 2x. Valuations can go down as well.
The first thing to establish is whether your stock options can be exercised before they're vested. If they are, this process can be easy. If not, then you need to manage the process more directly. There's a component of the Alternative Minimum Tax that that relates to stock options. There's a lot of information available on this as well. The key idea is that buying stock below its "fair value" forces you to recognize the difference between your price and its fair value as income. If your AMT liability exceeds the taxes you owe as part of the standard income tax, you have to pay extra when doing your taxes for that year (you also have to file some stuff; read up on 83(b) and AMT).
There is a huge, huge thing to know about the AMT. This is something I did not know, and that bit of ignorance has been enormously costly. This essential bit of information: if you pay AMT as a result of exercising stock options, you can get it back later. Again, I'm not a tax lawyer or an attorney, but you can find a lot of support for this.
If you spread your exercises over multiple tax years, you'll avoid or reduce your AMT liability in each year. This obviously saves you money up front. However, the later you wait to exercise, the more likely your investment will end up being a short-term one, and thus getting taxed at the normal income tax rate. If you exercise all of your options as early as possible, you will likely pay a much higher alternative minimum tax in that year.
However, and this is the crucial part, you will maximize the chances of holding those shares for the year and a day required to consider them long-term investments, and you will get that money back. You're basically loaning the IRS some money at 0%.
That's a lot better than paying an extra 25% to 30% of your capital gain. The 2012 top tax rate is 35%, turning to 39.6% in 2013. Those apply to short-term gains, while it's only 15% for long term gains. Avoiding 25%-30% in taxes is like getting +33% to +43% return on your investment. Note that this is far different from evading your taxes. The government wants you to hold investments for a long time; that's why they have a lower tax rate.
Returning to the question of whether you can exercise unvested shares. If you can exercise them, and you're confident of their long-term value, exercise as soon as you can. You will have to pay extra taxes up front, but you can get that money back. If you leave the company, even involuntarily, they have to give you your money back for whatever was not vested at the time of departure.
If you cannot exercise unvested options, try to exercise in quarterly tranches. Vesting is usually monthly, but quarterly is close enough. Annually isn't good enough. That means more paperwork, but every time you do so, you're increasing the chances of turning your investment into a long-term one. If doing this saves you $500 each time, it's easily worth it.