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Tax Center: Tax Changes 2003–2014

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Tax Planning For Options, Restricted Stock, And ESPPs After 2013 Tax Law Changes: High-Income Taxpayers Impacted Most (Part 1)

Tom Davison and William Whitaker

The beginning of 2013 brought notable tax-rate changes, but generally only for people with higher incomes—starting around $200,000 per year. Many taxpayers will still operate with the same rules they have had under the Bush tax cuts that became effective in 2003. This article series summarizes the main changes and explains various planning ideas.


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

Tax Planning Now More Valuable, More Complicated, With More Payoff For Stock-Based Compensation

Starting in 2013, the tax picture and tax planning that applied in previous years are relatively unchanged for single taxpayers with yearly income of less than $200,000 and married joint filers with yearly income of less than $250,000, as they are still generally using the rates under the Bush tax cuts. Above those levels, there are tax-rate changes from the American Taxpayer Relief Act (ATRA).

Under ATRA, taxes become more progressive (meaning: higher). The rates go up on income, long-term capital gains, and qualified dividends, and new phaseouts come into play. Separately from ATRA, people with yearly income above the $200,000/$250,000 threshold face two Medicare tax changes under the health care reform law. The new 3.8% Medicare surtax on net investment income especially affects stock-based compensation via capital gains and dividends. Also, for these taxpayers an extra 0.9% is added to the Medicare payroll tax. Many people, especially in states with high income and real estate taxes, have long been subject to the alternative minimum tax (AMT). Some changes affect both the AMT and regular tax in similar ways (e.g. long-term capital gains rates, 3.8% Medicare surtax, 0.9% extra Medicare payroll tax), but others affect the two tax systems differently as income rises, which can result in more or less AMT being owed.

Alert: All in all, 2013 brought a tax code that is more complicated and expensive. Hence, tax planning has become more intricate and tax bills are going up, especially for people with yearly incomes that are over a couple of hundred thousand dollars.

Tax planning is more important than ever. Multi-year planning is especially valuable with stock-based compensation, as you can control the timing of sales and option exercises and know when restricted stock/RSUs will vest. This added income often brings higher tax rates. A practical observation is that at these higher tax levels and higher complexity, any detailed tax planning should be done with good tax software or by a tax professional.

Tax-Bracket Changes: Nominal Marginal Rates

The 2012 nominal tax brackets remained the same after 2012, but the top of the 35% bracket moved to a 39.6% bracket (indexed for inflation, so the thresholds will rise over time). In 2014, this highest rate of 39.6% applies to taxpayers with yearly taxable income of over $406,750 for individuals and $457,600 for married couples. In 2013, the thresholds were $400,000 and $450,000.

Income tax bracket rates, 2003–2012 Post-2012 income tax bracket rates Post-2012 long-term capital gains tax rates
10% 10% 0%
15% 15% 0%
25% 25% 15%
28% 28% 15%
33% 33% 15%
35% 35% 15%
35% 39.6% 20%

Effective Marginal Tax Rates

In addition to the new tax rates, 2013 brought a number of important changes for high-income taxpayers. The tax-rate table shows the nominal marginal tax rates. "Marginal" means tax on the next dollar of income, and "nominal" means in name only. The rate table does not address the whole story. When doing tax planning, you want to know the impact of a change. For example, what is the net tax impact of an option exercise or the vesting of restricted stock? The effective marginal tax rate describes the actual change in your tax bill for the next dollar of income. Effective marginal rates bring in all the tax rules, e.g. those involving deductions and phaseouts of deductions.

Example: To find your effective marginal rate, compute your tax and then add $100 of income to see the tax change. If adding $100 of income raises tax by $43.40, your effective marginal rate is 43.4%. As we'll explain in this article, this could result from the combination of the 39.6% tax bracket and the 3.8% Medicare surtax.

Phaseouts For Itemized Deductions And Personal Exemptions

In 2014, itemized deductions and personal exemptions are phased out for single filers with yearly adjusted gross income (AGI) of more than $254,200 ($305,050 for joint filers). Itemized deductions are reduced by 3% of AGI over those thresholds (a.k.a. the Pease Limitation). The total reduction can't exceed 80%, and you will always get to use at least the standard deduction. The itemized deduction phaseouts increase the effective marginal tax rate by about 1% (precisely 3% of the relevant tax rate: 3% x 33% = 1%; 3% x 39.6% = 1.2%).


Pay attention to where phaseouts both start and finish.

Also starting in 2013, personal exemptions are reduced by 2% for each $2,500 of AGI above the same thresholds, adding about 1% per exemption to the marginal tax rate. In 2014, with personal exemptions of $3,950, the phaseout is complete at $376,700 of income above the threshold for single filers (for joint filers, the phaseout is complete at $427,550 of income above the threshold). A married couple with 4 dependents has 6 exemptions and their effective marginal rate increases about 6% during the phaseout.

Alert: Don't end up with income right at the top of a phaseout range, where you just finished paying for all the phaseout. Ideally, you want to be completely below, or well above, an expensive phaseout. Pay attention to where phaseouts both start and finish. If an option exercise or a stock sale hits the top of a phaseout, consider making another—it may be cheaper than waiting until next year and ending up in the same phaseout range.

Medicare Payroll Tax Adds 0.9% For High Income Taxpayers

The long-standing Medicare payroll tax rate is 2.9%, of which you pay half (1.45%) and your employer pays half. Starting in 2013, an additional 0.9% tax is applied on yearly earned income of more than $200,000 (single filers) or more than $250,000 (married joint filers). This tax applies to the income from nonqualified stock option and SAR exercises, the vesting of restricted stock/RSUs and performance shares/PSUs, and purchases in a nonqualified ESPP, as well as to wages and bonuses that push you over the threshold. Medicare tax is automatically withheld by your employer. It adds to your effective marginal rate but may not show up on your tax projection, as it is normally handled automatically by withholding.

Married couples can find themselves over- or under-withheld. Withholding for the extra 0.9% is based simply on each individual's income (i.e. compensation amounts over $200,000), and not marital status and exemptions. Your tax return trues up the proper amount.

Example: If you and your spouse each earn $200,000, no withholding for the extra 0.9% will have been done, but together your $400,000 of income is well over the $250,000 threshold. You will owe an additional $1,350 for the 0.9% on the $150,000 over the threshold: 0.9% x ($400,000 – $250,000). In another example, with only one employed spouse earning $250,000, excess tax will be withheld for the $50,000 over the threshold but will then be a credit on your tax return.

3.8% Medicare Surtax: Net Investment Income (NII) Tax

An additional 3.8% Medicare surtax also started in 2013, and applies to a new concept: net investment income (NII). Again, the income thresholds are $200,000 for individuals and $250,000 for couples filing jointly. The surtax applies to unearned income—e.g. interest, dividends and capital gains, rents, and distributions from annuities. It does not apply to stock option exercises, restricted stock/RSU vesting, ESPP purchases, wages, tax-exempt interest, retirement plan distributions, and Social Security benefits.

Alert: Stock compensation can push you over these income thresholds. The surtax applies to gains realized from sales of company stock after exercise, purchase, or vesting.

The surtax applies to the smaller of either net investment income (NII) or the excess over the modified AGI threshold. The table shows examples for a single taxpayer whose threshold is $200,000 of modified AGI (MAGI):

Wages Net investment income (NII) Modified adjusted gross income (MAGI) Amount subject to surtax Surtax at 3.8%
$150,000 $50,000 $200,000 $0 $0
$150,000 $100,000 $250,000 $50,000 $1,900
$250,000 $0 $250,000 $0 $0
$0 $250,000 $250,000 $50,000 $1,900

Note that once your income is over the MAGI threshold, an increase in net investment income raises the amount subject to the surtax by the same amount. But an increase in wage income does not add to the surtax. Planning ideas for the current year include maxing out retirement plan contributions to lower your MAGI if your income is close to the threshold.

Long-Term Capital Gains Rate Increases For Capital Gains And Qualified Dividends

Paralleling the change in the top income tax rate, from 2013 onward the long-term capital gains rate is 20% for taxpayers with yearly AGI that exceeds certain thresholds. In 2014, this highest rate of 39.6% applies to taxpayers with yearly taxable income of over $406,750 for individuals and $457,600 for married couples. In 2013, the thresholds were $400,000 and $450,000. The rate remains 0% or 15% for taxpayers whose income is below those AGI levels. Remember that qualified dividends also are taxed at long-term capital gains rates. No one will actually pay at just the 20% rate: if your income is high enough to trigger the 20% rate, you are also subject to the 3.8% Medicare surtax. As a result, for single taxpayers in 2014, long-term gains and qualified dividends will be taxed at:

0% First two tax brackets: 10% and 15%
15% AGI under $200,000
18.8% AGI from $200,000 through $406,750
23.8% AGI over $406,750

State, Local, And Real Estate Taxes

So far we've talked about the federal tax system. Many state, local, and real estate taxes have been changing as well, and these taxes may treat income in different ways than those of the federal system. For example, some states tax long-term capital gains as income, without a special lower rate. Many states tax dividends as income at the full income tax rate rather than at the cheaper capital gains rate. In a state with 7.5% to 10% tax rates, the state tax is half the long-term capital gains tax.


AMT exposure is directly impacted with changes in state, local, and real estate taxes, as these are deductible in the federal regular tax system but not in the AMT system.

State, local, and real estate taxes impact your federal taxes in two main ways. First, they are deductible for federal regular tax, and the amount that actually could be deductible changed with the 2013 tax rules on phaseouts described above. Second, AMT exposure is directly impacted with changes in state, local, and real estate taxes, as these are deductible in the federal regular tax system but not in the AMT system. Especially for AMT planning (discussed in Part 2), it is important when doing a tax projection to pay attention to state, local, and real estate taxes to see the overall effect on your tax bills.

What's Next

Part 2 focuses on strategies related to capital gains, the AMT, and ISO planning, and on other tax-planning steps related to income-shifting.

Disclaimer: This document provides a general introduction to tax rules that are typically more involved than can be covered here. Please think of this document as a starting point and consult with your tax advisor to fully understand the rules and how they may apply in your situation.

William Whitaker and Tom Davison are financial advisors at Summit Financial Strategies in Columbus, Ohio. They regularly counsel individuals who have stock options, restricted stock, and other forms of equity compensation. Mr. Davison is on the Advisory Board of myStockOptions.com. This article was published solely for its content and quality. Neither the authors nor their firm compensated us in exchange for its publication.


People who read this article also read:
Tax Planning For Options, Restricted Stock, And ESPPs After 2013 Tax Law Changes: High-Income Taxpayers Impacted Most (Part 2)
American Taxpayer Relief Act And Medicare Surtax: Impact On Stock Option And Restricted Stock Strategies