We predict that year-end financial and tax planning will be more peaceful and certain in 2016 than it may be during the next few years. One way in which year-end tax planning in 2016 has been eased: Various tax-law provisions that in the past often needed yearly approval by Congress were extended through 2016 (or beyond) or made permanent by the PATH ACT in December 2015.

The chances of tax changes before the end of 2016, a presidential election year, are very low. The prospect of tax-rate increases or decreases is therefore not a big factor in decision-making at year-end 2016. However, before the close of 2017 a new president, who will have been elected on a platform including major tax reforms, will probably propose new tax laws, which would become effective in 2018. Anticipated tax changes (and uncertainty around them) may then affect your decision-making.

For now, however, all is quiet on the tax front. As with year-end planning in the past few years, tax changes since the enactment of the American Taxpayer Relief Act (ATRA) and the Affordable Care Act affect year-end planning in 2016, particularly for individuals with annual income of $200,000 or more. While joint filers with over $466,950 of taxable income in 2016 are hit hardest, they are not the only people affected by the changes in tax law.

Tax planning is now more important than ever. Multi-year planning is especially valuable with equity compensation, as you can control the timing of stock sales and option exercises, and you know when restricted stock/RSUs will vest.

Even if your taxes have increased or are likely to increase in the future, many experts say tax rates should never be the only reason for exercising options or selling shares at the end of the year. Instead, make investment objectives and personal financial needs, not tax considerations, the driver of your decisions. As part of your year-end and year-beginning tax planning, review your:

  • holdings of stock options, restricted stock/RSUs, and company stock
  • scheduled vestings in the year ahead and salary contributions allocated for ESPP purchases
  • deadlines for option exercises and the expiration dates of option grant terms

Having made these general recommendations, this article presents some ideas for tax and financial planning to review before the end of the year.

Editor's Note: See also two related FAQs for ideas on exercising stock options and on selling company stock at the end of 2016. In addition, other articles discuss year-end planning specifically for restricted stock and RSUs and employee stock purchase plans.
Alert: If you are tempted to sell appreciated stock before the end of the year and then buy it back in 2017, you may also be concerned about the wash sale rule. However, the rule applies only to stock sold at a loss. This means you can sell the stock at a gain and quickly repurchase without wash sale problems.

1. Understand tax rates and trigger points
2. Consider time value of tax money on NQSO exercise; estimated taxes
3. Remember additional Medicare tax
4. Calculate AMT when deciding about ISO and NQSO exercises

1. Understand your tax rates and trigger points. While keeping federal income tax rates the same for most people, ATRA and the Affordable Care Act significantly raised tax rates on ordinary income and capital gains for people with high incomes:

  1. Ordinary income is subject to a top tax rate of 39.6%, versus 35% before 2013. In 2016, this rate applies to single filers with yearly taxable income of more than $415,050 and to joint filers with yearly taxable income of more than $466,950.
  2. Long-term capital gains (and qualified dividends) have a top tax rate of 20%, up from 15% before 2013. This also affects single filers with yearly taxable income in 2016 of more than $415,050 and to joint filers with yearly taxable income of more than $466,950.
  3. The Medicare tax (normally 1.45%) is 2.35% for single filers with yearly taxable compensation income of more than $200,000 and joint filers with yearly taxable compensation income of more than $250,000.
  4. The Medicare surtax places a 3.8% tax on the lesser of an individual's total net investment income or modified adjusted gross income above $200,000 for single filers, or $250,000 for joint filers.
  5. Taxpayers with an adjusted gross income of $259,400 (single) and $311,300 (joint) in 2016 will be subject to the phaseout of itemized deductions and personal exemptions.

Tax rate Yearly income threshold in 2016
Top ordinary income rate (39.6%) Taxable income of $415,050 (single) or $466,950 (joint)
Other upper income tax rates: 25%, 28%, 33%, 35% Taxable income of $37,650, $91,150, $190,190, $413,350 (single); or $75,300, $151,900, $231,450, $413,350 (joint)
Top rate on long-term capital gains and dividends (20%) Taxable income of $415,050 (single) or $466,950 (joint)
Medicare surtax on investment income (3.8%) Modified adjusted gross income of $200,000 (single) or $250,000 (joint)
Additional Medicare tax on earned income (0.9%) Earned income of $200,000 (single) or $250,000 (joint)
Phaseout of itemized deductions and personal exemptions Adjusted gross income of $259,400 (single) or $311,300 (joint)

Tax planning is now more important than ever. Whenever you are considering exercising stock options or selling stock at year-end, you want to consider the thresholds that trigger higher tax rates. In general, you want to do the following:

  • Keep your yearly income under the thresholds for higher tax rates.
  • Recognize income at times when your yearly income and tax rates may, according to your projections, be lower.
Alert: Multi-year planning is especially valuable with equity compensation, as you can control the timing of stock sales and option exercises, and you know when restricted stock/RSUs will vest. Know the remaining room you have for additional income in your current and projected tax brackets. In your planning, you are looking for ways to shift income between years so that you are paying less tax.
Example: For married joint filers, the income threshold for the 39.6% tax bracket and the higher tax rates on capital gains and qualified dividends is $466,950 in 2016. Suppose you are a joint filer who will have $400,000 of taxable income in 2016 and projected taxable income of $420,000 in 2017. You also have a $100,000 spread on your nonqualified stock options, whose term will expire in March 2017. By exercising just enough options in 2016 to generate $66,950 of additional income (giving you $466,950 for the year), you can then exercise the remaining options in early 2017 and avoid the higher tax rates in both years.

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2. Consider the time value of tax money on an NQSO exercise and think about estimated taxes. It usually makes sense to avoid accelerating income (and the related taxes) into the current year. If you were planning to exercise nonqualified stock options (NQSOs) in 2016 or 2017, you want to see if this traditional strategy of deferring income to future years still applies in 2016, given the thresholds for higher tax rates outlined above, your income projections, and your own multi-year planning.

Delaying Exercises To January

Your company must withhold at least the applicable flat rate of federal income tax on the exercise of your nonqualified stock options. You can develop a tax-deferral strategy when the flat rate is less than your marginal tax rate. Waiting to exercise nonqualified stock options (NQSOs) from December of this year to January of next year may let you invest the funds that will be used to pay some of the tax for almost an additional year.

Given the thresholds for higher tax rates, and considering your own multi-year planning, you want to see whether the traditional strategy of deferring income to future years still applies.
Example: The rate for withholding supplemental income tax, including income from NQSO exercises and restricted stock vesting, is normally 25% (but rises to 39.6% for yearly supplemental income over $1 million). In a December exercise, at the end of the tax year, the additional tax will be due soon afterward, as you must file your tax return for that year before the middle of April. But in a January exercise, at the start of the tax year, payment of the additional tax can be deferred for 15 months, as late as the April of the following year, assuming you do not need to pay estimated taxes. For those who are in the 39.6% tax bracket this year and are fortunate enough to expect $1 million in supplemental income early next year, the advantage of waiting to exercise is lost.

Estimated Taxes

If income from your exercise will be subject to tax at a higher rate than the flat rate that applies at withholding, you should evaluate whether to pay estimated taxes when your total withholdings will equal or exceed one of the estimated tax safe harbors—either 90% of the current year's tax liability or 100% of the prior year's liability (110% if your adjusted gross income for the prior year was over $150,000)—the excess tax needs to be paid only when your return is due in April.

If you are within an estimated tax safe harbor but will owe more later, put aside money to pay the additional taxes with your tax return. If you are not, consider asking your employer to withhold extra taxes from your regular paycheck to cover the shortfall at option exercise or restricted stock/RSU vesting. The IRS also credits withholding taxes as if they were withheld equally throughout the year. This can retroactively remedy tax underpayments from earlier in the year and avoid a potential underpayment penalty.

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Project your income from equity awards to see whether it will trigger the 3.8% Medicare surtax on investment income and the 0.9% additional Medicare tax on compensation income.

3. Remember the additional Medicare tax. The Medicare tax rate (normally 1.45%) is 2.35% for single taxpayers with incomes over $200,000 and for joint filers with incomes over $250,000. This additional Medicare tax applies to income from the exercise of NQSOs or the vesting of restricted stock/RSUs. In addition, for people with yearly income above the same thresholds, a 3.8% Medicare surtax applies to investment income, such as dividend income and the capital gains from stock sales. By contrast with the income thresholds for some other taxes, these are not indexed for inflation.

Planning Idea

If your income will trigger the surtax next year (but not this year) and you have company stock you intend to sell soon, you may want to consider selling in 2016 rather than 2017 to avoid the additional 3.8% tax. For example, a person who has incentive stock options, holds ISO stock, and plans to sell the shares after one year may want to evaluate the impact of the current top capital gains rate, along with the Medicare tax on investment income. Lower taxes may result from selling the shares in 2016.

Alert: The 3.8% surtax does not apply to income from stock option exercises, restricted stock/RSU vesting, or the purchase of ESPP shares. It applies only to the gains from selling shares that have been held. However, income from exercise/vesting/purchase will increase your adjusted gross income. You may want to project your income from equity awards to see whether it will trigger the Medicare surtax on investment income and the 0.9% additional Medicare tax on compensation income. Depending on your projections, exercising NQSOs in 2016 that you planned to exercise in the next few years may avoid both higher potential ordinary income tax rates and these Medicare taxes.
Example: You and your spouse expect to have modified adjusted gross income (MAGI) of $175,000 in 2016 and $250,000 in 2017. This includes about $40,000 per year in dividends and capital gains, which are not subject to the 3.8% Medicare surtax in 2016 because your MAGI is below the $250,000 threshold. However, if you exercise NQSOs in 2017 and recognize ordinary income of $50,000, this additional amount will push your MAGI above the $250,000 threshold. You will then have to pay the 3.8% tax on the $40,000 in investment income, along with potentially higher ordinary income rates. The extra $50,000 of income will not trigger these taxes if you exercise in 2016, as your MAGI for the year will still be under $250,000.

Tax Difference Between 2016 Exercise And 2017 Exercise

2016 2017
Modified AGI $175,000 $250,000
Capital gains and dividends included $40,000 $40,000
Income from exercising NQSOs $50,000 $50,000
Modified AGI + NQSO exercise $225,000 $300,000
Subject to Medicare surtax? No Yes

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4. Calculate the alternative minimum tax (AMT) when deciding when to exercise ISOs and NQSOs. Thinking about exercising incentive stock options (ISOs) before the end of the year and then holding the stock? Make sure you or your tax advisor first prepares an AMT projection to see whether a tax benefit may arise from waiting until January of the following year. ATRA brought some welcome certainty to AMT planning, as the inflation-adjusted AMT patch is now a permanent part of the tax code (for details on this and other AMT-related changes under ATRA, see the FAQ on that topic).

If you also have NQSOs and are thinking about exercising them early in the following year, for two reasons a tax projection can help you decide whether an overall tax saving will result from exercising those NQSOs this year. First, your AMT from your ISO exercises might be so high that you can exercise NQSOs this year and essentially not pay any tax on the spread. This is because your ordinary tax may remain lower than your AMT, and the government gets the higher amount.

Second, exercising NQSOs before year-end might get you out of paying AMT and dealing with its complexities. Although the exercise of NQSOs generates regular taxable income, this might reduce your exposure to AMT by potentially making your regular tax higher than AMT.

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Next Article

Part 2 in this article series presents more ideas for year-end planning with stock compensation and company stock to avoid unpleasant tax surprises. These ideas include tips on the AMT, gifts, donations, and capital gains and suggestions for further tax and financial-planning strategies.

This article was originally written by a former partner of a major accounting firm, where he was the National Director of Personal Income Tax and Retirement Planning. The staff of myStockOptions.com have since updated and expanded it. This article was published solely for its content and quality. Neither the author nor his former firm compensated us in exchange for its publication.