Restricted Stock: Taxes Advanced

In addition, what may be different at year-end 2009 is the increasing likelihood of tax rate changes in the years ahead. President Barack Obama's ambitious health-care reform, the continued economic intervention to prevent bank failures and bolster the automotive industry, the ongoing wars in Iraq and Afghanistan, and an expected significant decline in tax receipts will probably spell the end for at least part of the 2001 tax cuts.

In 2006, President Bush did succeed in extending the lower tax rates on capital gains and dividends through 2010 (see a related FAQ). What will President Obama do? This remains uncertain, though he has proposed that the current tax law should sunset in 2011 to lower taxes for people who make less than $200,000 per year ($250,000 for joint filers) and raise taxes for those whose income exceeds these levels. If that is what happens, we could return to the pre-2003 tax code, in which the top bracket for marginal income tax was 39.6%. The old law also taxed long-term capital gains at 20% for the top tax brackets (not at the current 15%). The weak economy may be a mitigating factor in the timing of any tax increases; but in any case, we are unlikely to get much clarity on the issue until the 2010 Congressional session.

Some financial advisors who believe they can accurately predict what the White House or Congress will enact may feel that your year-end strategy for 2009 should be influenced by the probability of higher capital gains rates (for stock sales) and income tax rates (for stock option exercises and restricted stock vesting). We do not. See item 1 below for our reasons.

Market Volatility

	After the market volatility of 2009, examine your stock holdings for the kind of opportunities that a more typical year's market action wouldn't offer.

If 2008's dramatic market decline caused you to reconsider your financial plans, 2009's rebound may present opportunities you may not have thought you'd see so soon. The steepest market decline in 75 years wiped out many people's retirement savings, dropped many stock plan participants' options out of the money, and significantly reduced the value of rewards deferred or granted in the past several years. The 2009 rebound has seen the market recover some of those losses, and for some people it has produced significant short-term gains. Between now and the end of the year, it is important that you carefully examine your employee stock holdings for the kind of tax-saving and portfolio-management opportunities that a more typical year's market action wouldn't offer. (See item 4 below for a discussion of capital gains management. Also see my article about down-market strategies for more tips on riding difficult market conditions to your advantage.)

This year, most market participants' experience is not relevant to planning for the future or dealing with what has happened in the recent past. Market behavior assumptions, developed during the post-1945 economic expansion of the US and based on research, opinion, and empirical experience, is proving in many cases to be inadequate for explaining what happened or what may be the best choice of action. Therefore, we shouldn't assume that financial-planning assumptions will necessarily be the same in this environment either. But there are some principles of tax management and portfolio balance that we know for sure, and we discuss them in this article.

NQSOs And Restricted Stock: Little You Can Do

The spread between the exercise price and the market price of NQSOs is taxed as ordinary income at exercise (as is the value of restricted stock at vesting), and the tax is fixed on that date. If you know your tax bracket will be higher next year, or if you feel certain rates will rise substantially, you may want to consider straddling years for your NQSO exercise to take the compensation income in the lower tax year. With restricted stock or restricted stock units, you have no flexibility in choosing the tax year, as the vesting date is set. (See the section Restricted Stock: Taxes and the article specifically about year-end planning for restricted stock and RSUs.)

With NQSOs, unlike with ISOs, nothing at year-end can change the tax impact of your exercise earlier in the year, regardless of whether your company's stock price has dropped (or risen) since you exercised. After you exercise and hold NQSO stock, the holding period begins, and it is simply stock with no special tax status. Evaluate it like any other investment (a similar analysis applies to restricted stock after it vests). When you sell the shares, the rules of capital gains tax apply, as explained in the section Tax Center: NQSO Basics.

For NQSO holders who have already "maxed out" their Social Security tax in 2009 by earning over $106,800, any additional exercises before the end of the year will occur without Social Security withholding, letting you keep an additional 6.2% of the spread. (Medicare tax of 1.45% still applies, as it is uncapped.) The wage base for 2010 will be the same.

Thus, special year-end tax moves for optionholders generally apply more to incentive stock options (ISOs), which I discuss in my other year-end article. With these thoughts in mind, add the following items to your planning between now and the end of the year. (Note that the tax issues and treatment discussed above are similar for stock appreciation rights.)

1. Taxes should not drive decisions. Remember to never base any decisions solely on taxes or expected future tax rates. If in December you sell at $20, merely to "take advantage" of your loss for stock exercised at $30 per share earlier in March, you lose the opportunity for future appreciation in the stock. Should it double to $40 by February, you will miss out on a gain of $20 per share.

	Base exercise decisions on a determination that your company stock has peaked, on a need for money, or on a desire to seek diversification.

As we have pointed out in previous articles, you should almost never make exercise or sale decisions based solely on tax considerations. No advisors know with certainty what tax rates will be in the future. Although it might be a safe bet to guess that Congress will alter the tax code before the current laws sunset in 2010, loading ordinary income or capital gains into 2009 could end up being a terrible choice if the market continued to rally and it turned out you left a bunch of appreciation on the table.

You should always base exercise decisions on a determination that your company stock has peaked, on a need for money, or on a desire to seek diversification. You may come to these conclusions by a number of paths but "buy low, sell high" is still the only way to make money in the market. Yes, your profits will be taxed at possibly higher rates in the future, but you'll never get rich by taking losses! You may reduce your income taxes with a year-end sale, but you eliminate your real opportunity to make money over the long run.

For strategies in 2009 and 2010 that anticipate likely changes in tax rates, see a series of articles discussing possibilities for restricted stock, nonqualified stock options, and incentive stock options.

2. Make sure you can pay your taxes. Always double-check that you will have the money to pay your taxes. If you exercised NQSOs, you may owe some income tax beyond what your company withheld at exercise. When you exercise an NQSO, your company withholds federal, state, and Social Security taxes (see the section Tax Center: NQSO Withholding). However, most companies withhold federal tax at only the minimum required federal supplemental income withholding rate of 25% (35% for total yearly amounts of supplemental income in excess of $1 million). Similar withholding rates apply to the value of restricted stock at vesting. If you are in the 35% tax bracket, you may owe the additional 10% with your tax return (or through estimated taxes), unless you're fortunate enough to have made more than $1 million in supplemental income.

	If you exercised NQSOs, you may owe some income tax beyond what your company withheld at exercise.

In addition, if you were not an employee of the company when you exercised NQSOs (e.g., a consultant or contractor), the company might not have withheld taxes at all. Instead, it might have just given you an IRS Form 1099-MISC that reports the income. Ask your accountant or financial advisor to estimate your tax liability and then make sure you can cover it. This may mean you will need to sell more stock this year, but at least you will be confident of your ability to pay taxes.

3. Sell losers. In spite of the performance of the stock market in 2009, you probably still have some stocks whose prices are below what you paid for them, perhaps substantially. Consider selling stocks that have lost value since purchase, but only when you expect the stock to continue to lose value. The best reason to sell a stock is that it's no longer a good investment. You may even want to sell the stock if you think it is not going to appreciate as quickly as alternative investments. If you expect only a small recovery in your stock but believe the market is going to appreciate substantially, sell, harvest the losses, and purchase something else.

4. Know the rules on loss deductions. Sell if you can deduct the loss. If the stock you paid $10,000 to exercise is now worth $5,000 less, the sale will generate a $5,000 capital loss. This may reduce your tax liability, but the amount of the deduction depends on the rest of your tax situation, including the gains and losses from other stock sales and loss carryforwards from prior years.

	Sell if you can deduct the loss.

The tax law says you can offset losses only against the same type of income. This means you cannot use a $5,000 capital loss to offset $5,000 of your salary. However, you can use the $5,000 capital loss to offset a $5,000 capital gain. There is one small exception to the "matching" rule. You can use up to $3,000 of capital loss to offset $3,000 of ordinary income, carrying forward any unused losses to next year. Therefore, if you sell only enough stock to generate $3,000 of capital loss, you will most likely get a deduction for the full amount (see a relevant FAQ).

American investors lost $5 trillion in the market decline of 2008. If you are like many stockholders, you are carrying forward market losses. Consider taking capital gains by year-end to use them up if you think your company's stock is overvalued or you are overconcentrated in it. Many of my clients whose restricted stock and restricted stock units (RSUs) vested in 2007 and 2008 are carrying those shares at a tax basis above today's market price while their shares that vested in 2009, early in the year, are up substantially. We will be paying close attention, as we approach year-end, for an opportunity to sell the appreciated shares and an offsetting amount of shares from previous vestings, at a loss, in order to diversify, raise cash, and position ourselves for what may come in 2010 without any tax consequence.

5. Sell if you need money. Thanks to the 2003 tax cut and the 2006 extension, your stock gain at sale is taxed at the top long-term capital gains rate of 15% when you hold it for more than one year (for details of the tax reporting, see the special section Reporting Company Stock Sales elsewhere on this website). You should always remember that the stock market is not a good place for short-term investments. Last year and the first quarter of 2009 once again painfully showed this to investors who may have forgotten years like 1987 or are too young to remember 1929.

	If you need money to pay a university tuition bill in January: sell.

Should you need money to pay for your child's university tuition in January: sell. Although the market may be poised for a big jump, don't wait. If it drops instead, you may not be able to pay the tuition costs. Always keep your short-term cash needs out of stocks so that you can ride through any short- or long-term drops in the market. While we're on the subject of college tuition, for 2009 and 2010 the Lifetime Learning (HOPE) credit is replaced by a new higher-education credit of up to $2,500 annually per student for four years of college, not just for the first two years. It now also covers the cost of books. The credit begins to phase out at $80,000 of AGI ($160,000 for joint filers). If the credit is more than your income-tax liability, 40% of it is refundable. Also, the full credit is allowed against the AMT. For more on the use of company stock to pay for education, see the section Life Events: College Funding elsewhere on this website.

6. Consider gifting stock to relatives in low tax brackets. You may make annual gifts of $13,000 ($26,000 if you split the gift with a spouse) to any number of recipients without either affecting any portion of your lifetime gift tax exemption or paying gift tax (see the FAQ on gifting company stock). Financial advisors often tell high-net-worth clients with substantial estates to consider making annual stock gifts before the end of the year, up to these amounts. Depending on the size of your estate at death, a strategy for making lifetime gifts can reduce your estate taxes, particularly if the value of the shares rises significantly after the gift (which many hope will happen over the next several years, given the dismal performance of the markets in 2008 and early 2009). High-net-worth individuals should consider a grantor-retained annuity trust for their company stock.

	Through 2010, taxpayers whose taxable income is in the 10% or 15% bracket qualify for a 0% tax rate on long-term capital gains and qualified dividends.

The capital gains tax rate for long-term holdings may provide an even greater income tax incentive for making lifetime gifts. Through 2010, taxpayers whose taxable income is in the 10% or 15% bracket qualify for a 0% tax rate on long-term capital gains (not the normal 15%) and qualified dividends. This rate for the lowest tax brackets dropped from 5% to 0% in 2008. A gift-related planning opportunity exists here, but the window of opportunity has narrowed in recent years. (For more on this, see the article Zero Can Be Positive in the January 2008 issue of the magazine Financial Planning.)

The securities sold (e.g., by a low-income parent) must still be held for over one year (including the period you held them before the gift) to qualify for the 0% rate. Gifting company stocks to charities is also a possibility.

Alert: The "kiddie tax" (i.e., your tax rates, not your children's) will apply to stock sales by your children under the age of 19 as well as college students under 24 unless the students provide over half of their own financial support from earned income.

7. It's not too soon to plan for future years. If you have additional compensation income this year from your stock option exercise or restricted stock vesting and are not eligible to fund a Roth IRA or deductible IRA, you may want to consider funding a nondeductible traditional IRA. Even if you are covered by a retirement plan, such as a 401(k), at work, you can still take a full IRA deduction in 2009 if your modified AGI is less than $55,000 ($89,000 married filing jointly). A partial deduction is allowed until your AGI reaches $75,000 ($109,000, married filing jointly). The opportunity to contribute to a Roth IRA is phased out for those with modified AGI between $105,000 and $120,000 ($166,000 and $176,000, married filing jointly) in 2009.

	If you are already contributing the maximum to your 401(k), consider making a nondeductible contribution to a traditional IRA that you can convert into a Roth in 2010.

Starting in 2010, the income limit on conversions from traditional IRAs to a Roth IRA will be eliminated under the phased-in rules of the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA). This tax law also eliminated the rules that prohibited married separate filers from converting traditional IRAs to Roth IRAs. Therefore, more people than ever before will be eligible to make Roth IRA conversions. If you are already contributing the maximum to your 401(k) at work, now may be a good time to consider making a nondeductible contribution to a traditional IRA with the expectation that it can be converted to a Roth in 2010 or later. If you have not been making IRA contributions, because of the income restrictions, perhaps it's time to take a look at 2009 nondeductible contributions as part of your retirement savings plan (see the FAQ on Roth IRAs).

When you do convert your traditional IRA to a Roth IRA, you will owe ordinary income tax on the value of any tax-deductible IRA (speak with your tax advisor about the related calculation). For a conversion in 2010 only, you can split the taxes due over 2011 and 2012 (50% each year). Income from your stock grants can help pay this tax. Also remember to consider upcoming income from stock compensation (e.g. known restricted stock/RSU vesting) in your tax projections when you are deciding whether to convert.

Incentive Stock Options At Year-End

As we mentioned earlier, special year-end tax moves for optionholders generally apply more to incentive stock options (ISOs). For year-end planning specific to ISOs, please see the relevant article.

Editor's Note: For more year-end-planning ideas, explore the section Financial Planning: Year-End Planning on this website.

W.E.B. Bantling is the pen-name of a broker and financial advisor whose real name must, like his advice, remain a secret. Michael Beriss is a Senior Financial Advisor at Ameriprise Financial (Bethesda, MD). This article was published solely for its content and quality. Neither the authors nor their firms compensated us in exchange for its publication.