12 Ideas For Year-End Planning With Stock Compensation (Part 1)
Podcast included: In addition to reading this article, you can listen to our podcast on year-ending planning. For other podcasts, see the podcast section of this website.
The reforms in the Tax Cuts & Jobs Act (TCJA), which took effect in 2018 (see the related article), continue to affect stock compensation, including:
- modification in the income tax rates and income ranges for each bracket, including a reduction in the top rate
- changes in the calculation of the alternative minimum tax (AMT)
The additional Medicare taxes under the Affordable Care Act were not affected by the TCJA. They continue to affect year-end planning, particularly for individuals with annual income of $200,000 or more.
If you feel that the Biden presidency could lead to higher tax rates for you in 2021, you want to consider ways to accelerate income into this year (e.g. exercise nonqualified stock options, sell company stock with large capital gains). However, remember that it is hard to predict whether Joe Biden's tax proposals will become law and when they would become effective, e.g. prospective from a date in the future or retroactive to beginning of the year.
Some prominent financial advisors are suggesting various approaches related to income sources, assets, and deductions (see, for example, The Biden Tax Plan: Proposed Changes And Year-End Planning Opportunities). Many experts say that tax rates should never be the only reason for exercising options or selling shares, or waiting to do so, at the end of the year. Instead, make investment objectives and personal financial needs, not tax considerations, the primary driver of your decisions.
Checklist To Review
As part of your year-end and year-beginning tax planning, review:
- holdings of stock options, restricted stock/RSUs, and company stock
- scheduled vestings in the year ahead and salary contributions allocated for ESPP purchases
- expiration dates for outstanding stock options (and SARs) and deadlines for option exercises
- any estimated adjustments needed for the year ahead in the Form W-4 used for salary withholding (the IRS revised Form W-4 for 2020), as your W-4 rate is sometimes applied to stock compensation withholding too
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 the related FAQs for ideas on exercising stock options and on selling company stock at the end of 2020. 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 2021, 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.
The Tax Cuts & Jobs Act keeps the current seven income tax brackets, reducing the rates and changing the income thresholds that apply. The rates are now 10%, 12%, 22%, 24%, 32%, 35%, and 37%. This means you have lower rates for compensation income, interest, ordinary dividends, and short-term capital gains.
Key Income Thresholds In 2020 That Affect Your Taxes
|TAX RATE/IMPACT||INCOME THRESHOLD|
|Income taxed at 37%||$518,401 single
|Other upper income tax rates: 22%, 24%, 32%, 35%||For singles, taxable income starting at:
$40,126, $85,526, $163,301, $207,351
For married joint filers, taxable income starting at:
$80,251, $171,051, $326,601, $414,701
|Capital gains (long-term) and dividends (qualified) taxed at 20%||$441,450 single
|3.8% Medicare surtax on investment income; additional 0.9% Medicare tax on compensation income||$200,000 single
(modified adjusted gross income)
The flat supplemental wage rate for federal income tax withholding on stock compensation is based on the seven brackets. For amounts up to $1 million it is linked to the third lowest rate (22%). For amounts over $1 million it is linked to the highest rate (37%).
The 22% rate of withholding may not cover the actual taxes you will owe on the additional taxable income from stock compensation. You must therefore know the tax bracket for your total income and assess the need to (1) put money aside to cover the taxes, (2) pay estimated taxes, or (3) revise your W-4 for the remainder of the year to increase salary withholding.
Need For Multi-Year Planning Continues
Tax planning is more important than ever. Whenever you are considering exercising stock options or selling stock at year-end, you want to know your tax bracket and your predictions for future tax-rate changes. You want to consider the income thresholds in 2020 that would trigger a higher tax rate (see the tax tables above and in a related article). 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.
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: Suppose you are a joint filer who will have $260,000 of taxable income in 2020 and projected taxable income of roughly the same in 2021, putting you in the 24% tax bracket. You also have a $100,000 spread on your nonqualified stock options, whose term will expire in March 2021. By exercising just enough options in 2020 to generate $50,000 of additional income (giving you $310,000 for the year), you can then exercise the remaining options in early 2021 and avoid the higher 32% tax bracket in both years.
|NQSO exercise income||$50,000 per year when exercise over 2 years||$100,000 when take income in 1 year|
|Taxable W-2 income||$310,000||$360,000|
|Marginal tax bracket||24%||32%|
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 2020 or 2021, you want to see if this traditional strategy of deferring income to future years still applies in 2020, given the tax outlook, 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.
Example: As explained above, the flat rate for withholding supplemental income tax, including income from NQSO exercises and restricted stock vesting, is normally 22% (but rises to 37% 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 37% 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.
As explained in #1 above, 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.
The Affordable Care Act was not repealed by the TCJA, so planning for the related taxes remains important. 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 SARs or from 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. Unlike the income thresholds for some other taxes, these are not indexed for inflation.
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 2020 rather than 2021 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 2020.
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 2020 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 2020 and $250,000 in 2021. This includes about $40,000 per year in dividends and capital gains, which are not subject to the 3.8% Medicare surtax in 2020 because your MAGI is below the $250,000 threshold. However, if you exercise NQSOs in 2020 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 2020, as your MAGI for the year will still be under $250,000.
|Tax Difference Between 2020 Exercise And 2021 Exercise|
|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|
Thinking about exercising incentive stock options (ISOs) before the end of the year and then holding the stock? Tax reform will make it less easy to trigger the AMT. However, still be sure you or your tax advisor first prepares an AMT projection to determine your AMT crossover point and see whether a tax benefit may arise from waiting until January of the following year. Next year the exercise may not trigger the AMT.
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.
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.