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Financial Planning: Strategies

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Post-2012 Tax Changes: Uncertainty Clouds Planning For Stock Compensation

The myStockOptions.com Editorial Team

The current tax law is set to end at the close of 2012. The future tax treatment of equity compensation, and therefore the value of your grants, will be determined amid a flood of necessary new legislation affecting all areas of the tax system. A report published by the Joint Committee on Taxation in Congress lists the mighty number of tax provisions that are set to expire at the end of this year. (With your filed tax return in hand, you can base planning projections on possible new tax rates in 2013.)


The post-2012 tax treatment of equity compensation will be swept along amid a comprehensive flood of necessary new legislation affecting all areas of the tax system.

For concepts and strategies to consider in year-end financial and tax planning with equity compensation, see the articles and FAQs in the section Year-End Planning on this website.

"Taxmageddon"

The upheaval to come is well summarized by an article in The New York Times (Coming Soon: "Taxmageddon") by David Leonhardt, the Washington bureau chief of the Times. As the lowered tax rates of the Bush administration, reluctantly extended through 2012 by President Obama, are due to finally expire at the end of this year, the prospect of sudden tax increases for most people across the United States has become both economically and politically alarming on all sides in Washington.

President Obama and the current Congress have less than two months to agree (or not) on new tax legislation. "All in all," writes Mr. Leonhardt, "the end of 2012 will be unlike any other time in memory for the federal government." This is why, he explains, aides in Congress have begun bandying the term "Taxmageddon" (and only half in jest).

Tax Rates Affect The Value Of Equity Compensation

At myStockOptions.com, we are keenly watching for signs of what may happen to the tax rates after 2012. For equity compensation and company stock holdings, the prospect of higher tax rates ahead would affect year-end planning strategies around the acceleration of income into the current year and the delay of deductions. President Obama's 2013 budget seeks to extend the current tax rates for everybody whose annual income does not exceed $200,000 ($250,000 for married joint filers) but promises higher tax rates for incomes above that level. For those high earners, rates in 2013 would revert to the levels that existed before the Bush tax cuts:

  • the 33% and 35% ordinary income rates would rise to 36% and 39.6%
  • the 15% rate on long-term capital gains would go back up to 20%
  • qualified dividends would lose their favorable 15% rate and would be taxed as ordinary income, up to the top rate of 39.6% (this differs from previous budget plans, which proposed to let the lower rate continue)

These potential changes in income tax rates are only part of the story. Already set to start in 2013 are two changes in the Medicare tax that will affect high earners: a new 3.8% Medicare surtax on investment income (such as capital gains from stock sales) for people with annual incomes of $200,000 or more ($250,000 for couples), along with the rise of the Medicare tax on compensation income from 1.45% to 2.35% for those same taxpayers. These measures were adopted with President Obama's law for health-care reform. The Social Security rate is also scheduled to return to 6.2% from the temporarily reduced rate of 4.2% that was introduced in 2011 and then extended through 2012. These payroll taxes apply to all forms of equity compensation except ISOs and tax-qualified ESPPs.

Withholding Rates For Stock Compensation May Rise

The withholding rates for supplemental wage income will change with any increase the income tax rates, as they are tied to the current rates in the tax brackets. Currently, the standard supplemental withholding rates remains 25% for annual supplemental income of less than $1 million and 35% for amounts of supplemental income above the $1 million threshold during a tax year. If the current rates of income tax expire, these two supplemental withholding rates will rise to 28% and 39.6%.

Supplemental withholding rates, along with the Medicare and Social Security taxes, apply to the income at the exercise of NQSOs and stock appreciation rights; the vesting or share delivery of restricted stock, RSUs, and performance shares; and purchases in an employee stock purchase plan that is not tax-qualified. Your actual tax rate on this income may be higher, and the rates could rise after 2012, as discussed above.

Alert: When your withholding rate is less than your marginal tax rate, you may need to pay estimated taxes.

Alternative Minimum Tax


President Obama has proposed to replace the AMT with a simpler wealth tax, known informally in the news media as the "Buffett" rule.

Talk about reforming or repealing the perennially problematic alternative minimum tax (AMT) has bubbled up every few years over the past decade. Amid the coming tax changes, the subject of ending the AMT has predictably resurfaced. In the latest idea, President Obama has proposed to replace the AMT with a higher tax rate for the wealthy. The proposal seeks to ensure that people with annual incomes of more than $1 million always pay at least 30% of their income in federal tax. This is the so-called "Buffett" rule, named after billionaire Warren Buffett, who famously pointed out that people who make most of their income from investments (like him) have lower tax rates than many wage-earners who toil for a living (like his secretary). However, this proposed change in the tax code faces a long road of opposition in Congress.

Ending the AMT would help everyone who has incentive stock options, as the spread at ISO exercise is currently part of the AMT calculation. While there are strategies to minimize the AMT, or to at least manage it if you have triggered it, they are a hassle for anybody who exercises ISOs and holds the shares.

Meanwhile, the AMT income exemption amounts for 2012 have not yet been determined. During past years, in what is termed the AMT patch, they have been increased slightly for inflation while remaining similar to those of the prior year. In 2011, the exemption amounts were $74,450 for married couples filing jointly and $48,450 for singles.

The Large Gift-Tax Exemption Will End

The Tax Relief Act of 2010 also made significant changes to the gift, estate, and generation-skipping transfer tax regimes. Under the law, the amount each individual can give without incurring tax (currently 35%) grew from $1 million to $5 million (in 2012, $5.12 million for singles and $10.24 million for couples). After 2012, the exemption will return to $1 million and the top tax rate will go back up to 55%, so those who have decided to use their full exemptions may want to do so before the end of 2012. This is one way to effectively transfer tax-free large holdings of company stock out of your estate, as explained in a related article.

Helpful Articles On Financial Planning In An Uncertain Tax Environment


As our planning content shows, the likelihood of higher tax rates in the near future should not be the only factor in your financial planning for stock compensation. Even a modest rise in your company's stock price will offset a tax increase.

For people with equity grants or nonqualified deferred compensation, financial planning in 2012 may end up feeling a lot like it did in 2010. There will be uncertainty about future tax rates and probably no decisive action by Congress until the very end of the year (at the earliest). However, unlike the situation in the tax standoff of 2010, changes are now much more likely to occur—one way or another. Either the current tax cuts will expire, raising the rates, or the tax code will be reformed altogether (if so, probably during 2013 with an extension of the current rates for one more year). Having already deferred these tough tax-law decisions for two years in 2010, Congress and the White House will be under much more political pressure this time to find a tax system that is seen to be fair while still having a meaningful chance of reducing the federal budget deficit.

With tax increases in mind, now may be a good time to re-evaluate your current financial-planning strategy. Should you take action with equity awards and company shares now or wait until new rates apply? Elsewhere on this website, see the article series How Tax Rate Changes Impact Your Stock Grant Strategies, in the section Financial Planning: Advanced. The articles provide an analytical framework to help you determine the impact of a tax increase. In general, the analyses and examples in the articles show that, in most situations, the likelihood of higher tax rates in the near future should not be the only reason to exercise nonqualified stock options or sell shares received from restricted stock vesting, an option exercise, or an employee stock purchase plan. Even a modest appreciation in your company's stock price will offset the tax increase, as you can see by using the calculators and modeling tools on this website. Investment objectives and financial needs, not tax rates, should drive your decisions.

For people with nonqualified deferred compensation, the website myNQDC.com is a helpful resource. It has insightful content on decision-making for salary and/or bonus deferrals amid the prospect of higher future tax rates. Key articles on this topic include the following:

Depending on the length of the deferral period, even with higher future tax rates you typically come out ahead by deferring your salary or bonus, as these commentaries and our NQDC calculator show.


People who read this article also read:
Restricted Stock & Stock Options: Financial Planning After Your Tax Return Is Filed (Part 2)
Tax Planning For Options, Restricted Stock, And ESPPs After 2013 Tax Law Changes: High-Income Taxpayers Impacted Most (Part 1)
How Tax Rate Changes Impact Your Stock Grant Strategies (Part 1): Nonqualified Stock Options
How Tax Rate Changes Impact Your Stock Grant Strategies (Part 3): Incentive Stock Options
How Tax Rate Changes Impact Your Stock Grant Strategies (Part 2): Restricted Stock
Using The Gift-Tax Exemption Amounts
Better Late Than Never: Stock Option Strategy For The Market Upturn
Restricted Stock & Stock Options: Financial Planning After Your Tax Return Is Filed And At Year-End (Part 1)