Year End Planning Tips for your Employee Equity Compensation
Employee Stock compensation is one of those things that you know you should be doing something with but really only give it any thought when you are forced to do something, like approve an option grant. Even if you aren’t checking every day, you should at least review your total employee stock plan once a year. Not only should you see if you are reaching your retirement goals and how your company stock plan impacts it but you should review your tax situation as stock compensation has a direct impact on this. Year end is the best time to do this as you have plenty of time to still make decisions that can impact the current tax year.
Review your Total Portfolio
It’s a good idea to keep tabs on your 401(k) plan, IRAs, and other retirement accounts but you should also review your stock plan and see how it relates to the rest of your portfolio. If you have Incentive Stock Options (ISOs), Non-Qualified Stock Options (NQSOs), Restricted Stock Units (RSUs), Employee Stock Purchase Plan (ESPP), or Stock Appreciation Rights (SARs) you need to factor them into your planning.
You should have a general idea of how each of these instruments work but more importantly you should know how much exposure you have to your company’s stock. With a lot of equity compensation, regardless or what form it comes in you might be building up a highly concentrated position, which can pose significant risks to your overall retirement plan but also your tax plan.
Now’s a good time to review your grant, vesting, and expiration dates as well. This will allow you to make better decisions today, knowing how much stock exposure you will have in the near future and how much you can remove in a tax efficient manner.
This exercise will help you understand where you sit now, what your options are, and if there are any planning opportunities to take advantage of.
Consider Selling your ESPP Plan Shares
A lot of ESPP plans allow you to purchase your employer’s stock at a discount. This can be a big incentive but can also lead to more risk than you would otherwise like to have in your portfolio. Reviewing frequently will allow you to assess this risk and take action to remove it.
Remember, you don’t pay any tax on your ESPP plan shares until you actually sell them and you are using after-tax dollars to make the purchase. When you sell the stock you owe ordinary income taxes on the gain, i.e, the difference between the discounted purchase price and the current market value. However, if you hold the shares long enough to be a Qualifying Position, you could pay favorable long-term capital gains rates on the gain above the discount you received. Knowing this will help you decide what to do with your shares.
If you already have a large concentrated position in your company’s stock, then you might be OK paying a little more tax to reduce your exposure to the stock. Just be mindful of your marginal tax bracket and how much room you have until the next bracket.
On the other hand, if you have little exposure to your company’s stock and therefore, not as much risk, you might make the decision to hold onto your ESPP plan shares until they reach the point of being a Qualifying Position and save a little on taxes.
As for the shares that have already achieved this status, consider selling them (being mindful of the total tax impact) since you likely will not be paying less than the capital gains tax rates (0%, 15%, or 20%) in the near future and are then able to diversify your portfolio. A tax projection before the year end will help greatly with your decisions around your ESPP shares.
Exercise ISOs up to AMT Crossover
If you don’t expect to owe any Alternative Minimum Tax (AMT) on your tax return when you file, you should look at exercising your in-the-money incentive stock options up to the AMT crossover point, when the bargain element is enough to equalize (or close to it) your tentative minimum tax and your regular tax. This will ensure you are not paying any AMT.
This type of strategy not only allows you to “start the clock” on having a Qualifying Disposition on your ISO shares exercised and held but also you can exercise without the cash outlay normally required to cover the AMT. However, you will have to pay the cost of exercising since you will not be selling the shares right away which would normally cover the withholding costs. This means you are also at risk of fronting the money only for the stock to decrease in value later.
Get Rid of your Incentive Stock Options that Have Decreased in Value
If you exercised and held ISOs early in the year, now is the perfect time to review these positions to possibly create a disqualifying position intentionally. If the market value is less than when you exercised you can reverse the AMT preference item, thus removing your AMT, by selling the shares before the end of the tax year. Remember, the Bargain Element is what is used to calculate your AMT and can have a large impact on your total taxes.
The act of selling is what turns your transaction into a disqualifying position and therefore, you’ll have to report the spread between what you paid (exercise price) and the market price on your tax return. While this is ordinary income, it could allow you to remove the stock position earlier than anticipated, better diversify your portfolio, and increase current cash flow.
Accelerate your AMT Credit
AMT as it relates to your ISOs is like prepaying anticipated income tax. Many times, this prepaying requires more than you otherwise would have to pay. When you eventually sell your ISO shares as a qualifying position, you might be able to receive and AMT Credit.
Therefore, year-end is an excellent time to consider selling your qualifying shares, utilizing your credit in the current tax year, reducing your overall position in your company stock, and creating a positive cash in-flow before year end.
Revisit your Restricted Stock Units (RSUs)
In general, you should sell the shares you received from your RSUs as they vest. This is because you have the pay the tax upon vesting regardless of whether you actually sell the shares. In practice, however, RSUs can vest automatically, transferring the shares into your taxable brokerage account, so your company stock can build up overtime. This can lead to a concentrated position and a lot more risk then you may want to have. Year-end is a great time to review your positions not only for previously vested RSUs but also upcoming vest dates for your remaining RSUs and set a reminder to deal with them when they vest.
Keep in mind, while tax are withheld when your RSUs vest (by selling some of the vested shares), you could still have capital gains (or losses) on the sale of the stock. This can lead to some tax planning opportunities by pushing some lots out to achieve long-term gains status, or harvesting losses to offset ordinary income in the current tax year (up to $3,000).
Accelerate Income into the Current Tax Year
A rule of thumb in tax planning is to push off taxes as long as possible. This advice is far too simplified to take at face value. Accelerating income is a great strategy which involves paying some tax now to avoid a lot more tax in the future.
If you anticipate lower income this year, it might make room in a lower marginal bracket to bring some income into the current year and avoid paying higher taxes compared to a more “normal” income year. This could be due to reduced bonus payout, less commissions, less RSU’s vesting, a temporary furlough or unpaid leave, or many other reasons. It doesn’t matter as much why your income is down as long as it reduces your income into a marginal bracket than your otherwise would be in.
A second reason to accelerate income is if you anticipate higher taxes in the future (current Tax Cuts & Jobs Act is set to sunset after 2025, increasing many taxpayers marginal tax rates). If this is the case, you may want to use your temporarily lower tax brackets to accelerate income for the next few years while your income is lower. Legislation in only one reason you might experience an increase in taxes, if you are on a partner track, or if you are obtaining a master’s degree, higher income might be coming in your near future.
Perform a Tax Projection
One of the most powerful tools we use in our planning process is the tax projection. It involves forecasting your tax return months ahead of time. Think of it like preparing your taxes ahead of time but without filing anything. Doing this before the end of the year allows you to make many of the strategies discussed above happen. If you know you have $10,000 left in the 24% tax bracket (the next bracket is 32%) you might want to accelerate income. If see you have some capital losses from earlier in the year, you might want to take some gains built in your ESPP plan or stock received from RSUs/Options. You will also be able to see if you are due a refund or if and how much you will owe by the tax deadline. You can then adjust withholdings or make estimated payments before the end of the year and avoid underpayment penalties.
While anyone can benefit from a tax projection, it’s especially useful for executives and highly compensated employees with a lot of stock compensation as this can create dramatic swings in income. This is especially important considering the withholdings on these instruments do not always cover the taxes due.
Plan and Prepare for the Next Year
The end of the year helps you determine if anything needs to be done before the end of the tax year but also helps you chart the best course of action for the next year. Vesting dates, amount of stock compensation, and even the market can dramatically change your total financial situation in one year to the next. Without reviewing your overall financial plan, tax plan, and employee stock compensation you will inevitably pay more tax, work longer, and stress out more than you have to.
If you want someone to help you review your stock compensation, retirement plan, and tie it in with your tax planning, reach out to a Phillip James Advisor today for a complimentary meeting.