If you are reading this, you probably already know that exercising your incentive stock options (ISOs) can trigger an alternative minimum tax (AMT) hit. In this article we'll assume you understand all that stuff and just want some ideas on what you — an innocent ISO holder — can do to minimize or even avoid paying the dreaded AMT. Here's our best shot.

Exercise Sooner Rather Than Later
If you expect your company stock to rise steadily, exercising your ISOs shortly after they vest may keep you out of the AMT trap. Why? Because your AMT income is increased by the "spread" between market value at the time of exercise and the exercise price. For example, if your ISO gives you the right to buy 500 shares at $40, exercising when the stock is trading at $50 creates a spread of $5,000 ($10 per share times 500 shares). But exercising sooner — say when the market price is only $44 — minimizes the spread. A lower spread means less chance you'll owe the AMT.

Stagger Your Exercise Dates Over Several Years
Let's say the preceding strategy won't help because the stock has already risen substantially. Assuming your ISO doesn't expire before the year's end, you could do a partial exercise this year and defer exercising the rest until later. Again, this minimizes the spread in any one year and increases your odds of dodging the AMT.

Of course if the stock keeps rising, this strategy can backfire because the spread in future years will keep getting bigger and bigger. However, even if the stock keeps going up (heaven forbid!!), you might not just be postponing the inevitable by staggering your exercise dates. Congress could decide to liberalize the AMT rules, which could reduce your risk of owing the tax in future years when you will be exercising your remaining ISOs. In fact, it would not be shocking if this happens.

Do Everything Else You Can to Cut Your AMT Bill
If you can't avoid a big spread on your ISOs, you may still be able to limit the AMT damage by "managing" the rest of your tax return. In other words, if you can cut out some of the other stuff that contributes to your AMT problem, it lessens the negative impact of exercising your options. As explained in "The Alternative Minimum Tax," you have an AMT exemption that is, of course, phased out at higher income levels. (See the instructions to IRS Form 6251, Alternative Minimum Tax — Individuals, for a worksheet to calculate your exemption.) So reducing your overall income level for this year could increase your exemption and better the odds for escaping the AMT.

For example, you may be able to defer a year-end bonus from this year into next year. Or you may have some investment losers you could sell before the year's end to offset your gains. Lowering your income also cuts your state and local income taxes, which further reduces AMT exposure, because these taxes are deductible in figuring your "regular" federal tax but are nondeductible for AMT purposes.

Finally, avoid tax-free munis that are "private activity bonds." While these are indeed tax-free under the "regular" tax system, the interest counts as income in computing the AMT.

Don't Exercise Until the Last Minute
Another AMT reduction strategy is to consider your ISO "money in the bank" when the underlying stock appreciates beyond the exercise price. Why not just sit on that option and use the funds you would otherwise expend on exercising to acquire another equity stake? This could be more stock in your employer, or you could diversify your portfolio (and reduce your risk) by picking up some shares in other companies.

No exercise means no AMT, and as long as you hold the alternative equity stake over 12 months, you'll pay only 15% on the gains from that position. When you sell, you can use the after-tax proceeds to exercise your ISOs.

Even if you then turn around and immediately sell the company stock — making a "disqualifying disposition" — you could still come out ahead, despite paying taxes at your ordinary rate. (There's no AMT hit when you exercise an ISO and sell the shares in the same year.) In essence, you have positioned yourself for two gains instead of one, and that (hopefully) more than compensates for the additional "regular" tax on your gain from selling the ISO shares.

Here's an example. As before, let's assume you have an ISO to buy 500 company shares at $40. You could exercise when the price hits $44 (a 10% premium), and at worst take a minimal AMT hit. But you would have to invest $20,000 to pull the trigger.

On the other hand, you could invest the same $20,000 in shares of several other companies. Say both the company shares and your alternative equity portfolio appreciate 25% over the next three years. Now your ISO is about to expire, so you have to exercise. You sell the alternative portfolio and pay 15% on the $5,000 gain, for a net profit of $4,250. You then take $20,000 and exercise your ISO on the company stock, which is now trading at $55. If you immediately sell, you'll owe tax at your ordinary rate (say 28%) on the $7,500 gain ($27,500 proceeds less $20,000 exercise price). After taxes, you're left with $5,400 (72% of $7,500), for a combined net on the two transactions of $9,650.

If you had spent $20,000 to exercise the ISO, your after-tax net would be only $6,375 (85% of your $7,500 profit), and this ignores any additional AMT you might have to pay in the year of exercise. (If the alternative portfolio goes down, this was a bad idea. But nothing ventured, nothing gained.)

Make a Disqualifying Disposition in the Same Year You Exercise
Another way to avoid the AMT is to sell your ISO shares in the same year you exercise. Of course, this means a disqualifying disposition and you'll owe tax at your ordinary rates on the gain. However, at least you won't owe any AMT. Before you say that sounds smart-alecky, step back for a minute. In a declining market, a disqualifying disposition is certainly better than watching your shares plummet so far below the exercise price that making any profit at all now seems hopelessly optimistic.