Tax errors can be costly! Don't draw unwanted attention from the IRS. Our Tax Center explains and illustrates the tax rules for sales of company stock, W-2s, withholding, estimated taxes, AMT, and more.
Retirement Planning With Stock Options, Restricted Stock, And Other Stock Compensation (Part 1: Pre-Retirement Planning)
You have always intended to use the income from your company's stock grants to comfortably retire. Yet you've never had a specific plan for how to use these grants, or understood the retirement-related issues. Whether you have stock options, stock appreciation rights (SARs), restricted stock, or restricted stock units (RSUs), this three-part article series discusses the issues to consider when you plan for retirement, approach retirement, or have retired already.
Timeframe For Retirement Planning
When you are at the peak of your career, raising a family, or paying for children's college educations, it is difficult to think about planning for your own retirement. There may be no surplus cash flow to save. Nonetheless, the decisions that you make during your pre-retirement years directly affect when you can retire and what level of income you can enjoy in those years. You should begin to plan for your retirement at least 10 to 15 years before your target retirement date, if not earlier.
How Stock Options Fit Into Your Retirement Goals
People often think about "The Number" they need to reach to retire comfortably. This is usually the value of your investment assets on your retirement date that you require to live comfortably until the day you die. However, there is no such thing as one magic number for someone. Rather, the amount you need changes daily with dozens of variables such as your family's employment status, your health, your standard of living, your children's needs and wants, the financial markets, and more. Thus you should re-evaluate your progress toward retirement at least annually.
If stock options are a significant part of your portfolio, the analysis becomes even harder. You should not view options in the same way you view other stocks or mutual funds. While options are an equity component, they are much riskier than stocks you own outright, or unvested restricted stock. Stock options can be highly volatile, and the percentage of your investment portfolio they make up can change daily. In addition, they are concentrated in one stock (your company's).
Compounding this, you may also have large amounts of company stock in your 401(k) plan. Finally, you do not directly control the size of option grants and other stock grants you receive each year. It doesn't usually make sense to exercise your stock options early without having a much better investment opportunity somewhere else. Therefore, you have to coordinate your other investments around your stock options.
Example: Your age indicates that you should have about 50% of your investment assets in equities, of which 9% should be small-company-growth stocks, 13% should be international stocks, and 28% should be large-company stocks. Assume also that your options make up 56% of the value of your investment assets. Don't think that you have the entire equity component covered by the value of your options. You should count the options toward only the 9% of small-company growth and add to the international and large-cap components until they reach the desired levels for your age.
What Happens To Your Outstanding Stock Grants When You Retire?
Stock grants almost always have vesting provisions, which are usually based on your continued employment at your company. Once you retire, your stock plan will detail when or whether vesting continues or stops. Retirement is a type of termination under most stock plans. Companies treat retirement more generously than termination of employment to work for another company. Closely review your stock plan provisions for the rules and definitions that apply to "normal" retirement and "early" retirement (if it makes this distinction). Then choose a retirement date that maximizes the number of vested options and shares.
According to a 2013 survey by the National Association of Stock Plan Professionals (NASPP), a small minority of companies either let the options continue to vest normally or accelerate the vesting upon normal or early retirement:
The NASPP's 2013 survey found the following prevalent treatments of restricted stock/RSUs upon retirement:
At certain companies, these provisions depend on the number of years you worked at the company before retirement. For example, the provisions may apply after you have worked at the company for 20 years. When you near retirement, it is important to review these provisions in your stock plan and in your specific grants.
Alert: Even if your company allows vesting to continue or accelerates vesting, as soon as you are no longer employed by your company, you must exercise incentive stock options (ISOs) within three months of ending your employment to prevent them from becoming nonqualified stock options (NQSOs). Because ISOs are taxed more favorably than NQSOs when you exercise and hold the shares, you should take a careful inventory of all your options upon leaving your company. These issues, including the exercise rules at and after termination that you must follow to avoid forfeiting valuable stock options, are discussed in detail in Part 2 (see also a related FAQ).
This planning process is particularly important when you expect your stock options (or SARs) to account for a large part of your retirement nest egg. Decisions about stock options should begin at the moment of each grant. To prevent all the stock options from becoming due at retirement, most people should begin a regular program of exercising options well before retirement. This also helps you diversify should too much of your net worth be linked to movements in your company's stock price.
Over time, a few option exercise strategies have emerged as "tax sensible," regardless of whether you save or spend the option proceeds. However, do not let taxes alone control your decision-making. Although you should carefully evaluate the tax implications of transactions, do not lose sight of the general economics. This is hard to do because of the difficulty in predicting with any degree of accuracy the future value of your company stock or the lost opportunity cost of an alternative investment for your gains.
Thus, although the tax consequences of a tax-planned strategy are fairly easy to calculate, the long-term economics are never guaranteed. Therefore, the next few planning suggestions are presented to explain the tax outcome and do not attempt to recommend the strategy offered. Additionally, you need to consider your unique facts and circumstances before executing any of the following suggestions.
ISOs And AMT
When you intend to exercise ISOs and hold the stock, it is generally prudent to avoid the alternative minimum tax (AMT) whenever possible. This takes proper planning and fine tuning. If the AMT is unavoidable, however, because a valuable ISO is expiring, the AMT should be recouped as quickly as possible in later years by using the AMT credits. You must then keep two sets of records: one to track the regular tax basis and the other to track the AMT basis of the stock acquired each year (see related FAQs on AMT credit). In addition, if you die with unused AMT credits, the unused credits do not carry over after death to your estate or beneficiaries.
You should design an option exercise strategy that minimizes the overall AMT paid in connection with the exercise of ISOs (see a related FAQ for a range of strategies). One popular strategy is to exercise just enough ISOs each year to avoid triggering the AMT (see a related FAQ on this technique). The stock acquired by exercise of the options should be kept, if possible, for the required holding period of two years from the grant date and one year from the exercise date. Thereafter, the stock, for the full increase over the exercise cost, can be sold as needed at favorable long-term capital gains rates.
Another strategy for those who want to diversify involves exercising and selling options in alternating years. This is a more aggressive ISO exercise program. Under it you exercise ISOs and incur the AMT every year. As soon as you have kept the stock for the required one-year holding period (assuming the two-year holding period from grant to sale is also met), you sell it for long-term capital gain. You repeat this pattern every year so that each year includes an ISO exercise and a sale of stock acquired by the previous year's ISO exercise. This strategy works best when you want to diversify a large amount of stock over time, meet the long-term holding period, and sell the stock every year at favorable capital gains rates. Its primary disadvantage is paying AMT every year when the ISOs are exercised. Although some of the AMT can be recouped the following year when the stock is sold, you may never completely recoup the full amount of AMT that you paid. (See a related FAQ on selling ISO stock that triggered AMT.)
Nonqualified Stock Options (NQSOs)
You may want to wait to exercise your NQSOs if you believe that the stock's value will continue to appreciate until the end of the option term. Meanwhile, perhaps the money you would otherwise use to exercise the options and hold the shares is earning a better rate of return elsewhere.
In addition, the spread when you exercise NQSOs is taxable, so it grows "tax-deferred" until you exercise. Therefore, little or no tax or economic advantage would come with exercising the options prior to their expiration date and paying taxes earlier than necessary. Unless you have other considerations, such as a need for cash from exercising and immediately selling, or the lure of a more promising investment for the gains, you generally have no incentive for an early exercise.
Restricted Stock And RSUs
There is a perception that restricted stock and restricted stock units (RSUs) have more value than stock options because they always maintain some worth, even if the stock declines. Stock options, on the other hand, can lose all their value if the trading price dips below the exercise price. The security offered by restricted stock and RSUs becomes even more important as you near retirement. In addition, if your company pays dividends, you usually receive them along the way or at vesting.
However, stock options have greater upside potential and thus can produce more substantial wealth than restricted stock and RSUs. In addition, stock options give you more control over when you recognize the taxable income and generally provide longer "tax deferral" than restricted stock and RSUs, which usually become taxable at vesting within four years from grant (see the relevant FAQ on the taxation of restricted stock). Contrast this with stock options, which generally expire 10 years from the grant date. Ideally, your investment portfolio will contain both restricted stock and stock options.
Income recognized from exercising NQSOs or SARs, a disqualifying disposition of ISOs or ESPPs, and vesting of restricted stock is often included in your total income for the purposes of calculating the amount you can contribute to your company's 401(k) plan (confirm this with your company). Employee contributions to a 401(k) plan are limited to $18,000 in 2015. Those who are over 50 can add an additional $6,000 per year, for a maximum possible contribution of $24,000 in 2015.
Therefore, stock compensation may give you more money to contribute to your 401(k) plan when (1) your contribution amount is based on a percentage of your compensation and (2) your annual contribution is normally below the yearly maximum. You should confirm your individual situation with your 401(k) administrator.
The amount of yearly income which dictates your eligibility to contribute to a Roth IRA is called modified adjusted gross income (MAGI). This is your regular adjusted gross income (AGI) with a few differences (e.g. any income from the conversion of a Roth IRA doesn't count in MAGI). If your MAGI exceeds the Roth income limits for your tax return, you lose the ability to contribute to a Roth IRA. However, you can still convert a traditional IRA to a Roth IRA, using the gains from your stock compensation to pay the taxes (see an article on Roth conversions elsewhere on this website).
For the tax year 2014, the contribution limits for a Roth IRA are $5,500 for a person under 50, and $6,500 for a person who is 50 or older before the end of the year. To be eligible for maximum contributions in 2014, married joint filers must have MAGI of $181,000 or less, and single filers must have MAGI of $114,000 or less. The phaseout range for partial contributions extends from there up to an income ceiling of $191,000 for married joint filers (up to $129,000 for single filers), beyond which contributions are not allowed.
Alert: Up to the filing deadline of your 2014 tax return in April 2015, you can make contributions that still count for the tax year 2014. (IRS Publication 590-A has more information.)
For the tax year 2015, the contribution limits for a Roth IRA are $5,500 for a person under 50, and $6,500 for a person who is 50 or older before the end of the year. To be eligible for maximum contributions in 2015, married joint filers must have MAGI of $183,000 or less, and single filers must have MAGI of $116,000 or less. The phaseout range for partial contributions extends from there up to an income ceiling of $193,000 for married joint filers (up to $131,000 for single filers), beyond which contributions are not allowed.
Alert: Up to the filing deadline of your 2015 tax return in April 2016, you can make contributions that still count for the tax year 2015. (IRS Publication 590-A has more information.)
The effect of stock grants depends on the type of grant. ISO exercises do not generate income that is included in adjusted gross income (AGI). Therefore, if you exercised and held ISOs, the potential resulting alternative minimum tax (AMT) is not considered. But if the ISO is disqualified (e.g. by same-day sale or sale in the same year of exercise) and becomes an NQSO, the income is classified as "ordinary income" and goes into AGI. NQSOs and stock appreciation rights always generate ordinary income at exercise, and restricted stock/RSUs always do so at vesting, unless for some reason the IRS classifies the income as deferred compensation.
As for traditional IRAs, when neither spouse is covered by a retirement plan at work, there are no AGI limits for making a tax-deductible IRA contribution. However, when only one spouse is covered by a plan at work, the rules become more complicated and you should consult IRS Publication 590.
Turning Stock Grant Gains Into Deferred Compensation
Stock options are designed to compensate employees for job performance rather than to provide retirement benefits. Therefore, most employee stock options will expire long before you retire. However, you may not need the cash now or may be in no hurry to pay the taxes on the option gains at exercise. Under certain very special circumstances, you may be able to convert your option gains, assuming Section 409A of the Internal Revenue Code does not penalize it. (For details, see my article "Converting Your Stock Option Spread Into Nonqualified Deferred Compensation" elsewhere on this website.) With RSUs that vest during your employment, you may have the ability to defer taxation until retirement, as explained in another FAQ.
Part 2 of this series turns to the considerations for your planning in the year you retire from work.
Carol Cantrell is a CPA, lawyer, and financial planner with the law firm Cantrell & Cowan in Houston, Texas. She concentrates in financial planning for executives, families, and retirees, with a specialty in stock options, trusts, partnerships, and estate taxes. She is the author of the book Guide to Estate, Tax, and Financial Planning with Stock Options, published by CCH, a WoltersKluwer company. Parts of this article are based on that book. This article was published solely for its content and quality. Neither the author nor her firm compensated us in exchange for its publication.
People who read this article also read:
Restricted Stock: Tax, Financial, Estate, And Retirement Planning (Part 1)
Retirement Planning With Your Stock Options And Other Stock Compensation (Part 2: Retirement Year)
Converting Your Stock Option Spread Into Nonqualified Deferred Compensation
Retirement Planning With Your Stock Options And Other Stock Compensation (Part 3: Post-Retirement Planning)
Restricted Stock: Tax, Financial, Estate, And Retirement Planning (Part 2)
Ten Financial-Planning Rules Everyone With Stock Options Needs To Know