What are some key planning strategies at year-end for restricted stock, RSUs, and stock options?
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. (See a related article on this website in which several financial advisors predict that Biden's proposed tax changes will not occur in 2021.)
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
Decisions in year-end financial and tax planning depend on:
- your situation, including short-term cash needs that may prompt you to sell stock and/or exercise options
- whether your decisions should be entirely tax-driven
- what you did earlier in the year
- your outlook for both your company's stock price and your job
- multi-year projections for your income
- your ability to spread the recognition of income from certain sources over 2020 and 2021
- options that may expire soon
- trading windows and blackouts and/or ownership guidelines imposed by your company
With year-end planning, you are looking for ways to shift income between years so that you are paying less in tax, while also considering the outlook for your company's stock. If you are considering option exercises or stock sales at year-end, you should be aware of the thresholds for higher tax rates and may want to consider keeping your income below them, if possible.
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%).
Below we present several situations and some strategies that many experts suggest. Of course, you should consult a financial advisor about your individual situation. See also two other FAQs for additional ideas on exercising stock options and on selling company stock at the end of 2020.
1. You are planning to sell the stock at exercise late this year or early next year. You should calculate whether the ordinary income at the exercise of a nonqualified stock option will push you into a higher tax bracket and/or trigger the Medicare surtax on your investment gains, and what the taxes will be when the rates and bracket thresholds are adjusted for inflation in 2021. To break up the tax hit from an income spike, you may want to spread the same-day exercise/sale over the end of this year and the beginning of next year. Plus, you'll want to defer exercising into 2021 if you are confident your personal tax rate for the income triggered will be lower.
Alert: When you do sell company stock, reporting it on your tax return raises other issues. See the special section Reporting Company Stock Sales, with annotated examples, in the Tax Center.
2. You are over or near the yearly maximum for Social Security. The Social Security wage base for 2020 is $137,700 (it is $142,800 for 2021). Social Security tax (6.2%) is owed only up to that income ceiling (Medicare tax is uncapped).
- Yearly income already over that threshold: Exercise nonqualified stock options or stock appreciation rights in December without paying Social Security tax so that you can keep an extra 6.2% of the related income.
- If you wait until January, your yearly wage base restarts at $0, and Social Security tax will again apply up to the new maximum for that year.
- Beneficiaries can also avoid this tax by exercising options in the year after death.
3. Additional Medicare tax. The Medicare tax rate (normally 1.45%) is 2.35% for single filers with yearly compensation income of more than $200,000 (more than $250,000 for married joint filers). In addition, a 3.8% Medicare surtax applies to investment income, such as dividends and stock sale gains, for people in that same income range.
Alert: Unlike the tax provisions outlined in the table above, the income thresholds for triggering the Medicare surtax and the Additional Medicare Tax are not indexed for inflation. The amounts will persist unless Congress changes them.
Example: Your multi-year projections of income show that you will trigger this surtax next year. You have company stock or other investments that you intend to sell soon, you may want to avoid the additional 3.8% tax by selling this year instead of next year.
Additionally, if you exercised incentive stock options during the year, are holding the ISO stock, and have plans to sell the shares after one year, you may want to evaluate the impact of capital gains rates, along with the Medicare surtax on investment income. This may lead you to lower taxes by selling the shares at year-end instead of next year.
4. Examine standing orders. Year-end is a popular time to sell stock, but you should be aware of yet another tax change of the past few years that can hurt you later, when you file your tax return. In light of the shifts in cost-basis reporting for stock sales, consider whether to modify any default standing order in your account for the shares to use at sale. This is particularly important for stock you have acquired from option exercises, restricted stock/RSU vesting, and ESPP or open-market purchases at various times (i.e. the tax basis varies). Otherwise, the default order will automatically be "first in, first out" (FIFO) when you sell the company stock.
Under the current rules, a standing order can be changed only up to the settlement date (now within two business days of the transaction under the T+2 rules that took effect in Sept. 2017). Previously, you could get away with just indicating the sold shares on your tax return.
Alert: If you have company stock in your account from various types of equity compensation, such as shares from ISO exercises, ESPP purchases, and RSU vesting, when you sell the shares be sure that you identify the ones you want to use. Selling other shares unintentionally may trigger unwanted tax consequences (e.g. a disqualifying disposition of ISO or ESPP stock). This situation may require a change in the standing order.
5. Your restricted stock or restricted stock units (RSUs) vested this year. Unlike stock options, which trigger taxes when you choose to exercise them, restricted stock and RSUs usually give you no control over the timing of your taxes because you are taxed when the shares vest. (The two exceptions to this are rare: opting to be taxed at grant instead by making a Section 83(b) election, which is unavailable for RSUs, or having RSUs with deferral features.)
At vesting, you own the stock outright and have taxable W-2 income. Therefore, you can try to plan the timing and shifting of other income around this restricted stock/RSU income, as suggested in #1 above. See also the considerations in #7 about whether to continue holding the stock after vesting, which are similar to the question of whether to hold NQSOs exercised this year.
6. You exercised incentive stock options (ISOs) this year, you still hold the stock, and the stock price dropped substantially. While the changes in the AMT calculation under the TCJA make it much less likely you'll trigger the AMT, it is still important to calculate whether you should sell the stock this year (i.e. a disqualifying disposition) to eliminate any alternative minimum tax on the spread at exercise. Not doing this "escape hatch" analysis near the end of the year, especially if your company's stock price fell after an exercise earlier in the year, is a big mistake that many people with ISOs make. Should you decide to sell the stock, to avoid problems with the wash sale rule do not repurchase company shares within 30 days after the sale. Look at other FAQs on this website to help minimize or manage the AMT liability that can arise from ISOs.
7. The stock price rose (or fell) after your exercise of nonqualified stock options (NQSOs) or your restricted stock/RSU vesting this year. The tax treatment is fixed at the time you exercise options or stock appreciation rights (SARs), and when restricted stock (assuming no 83(b) election) or RSUs vest. This is the tax rule for your federal and state income tax, regardless of the future stock price and whether you hold or sell the stock. You may have planned to sell the stock at price targets after holding it long enough to receive long-term capital gains treatment, but the stock price fell significantly. Therefore, you may want to consider selling the stock to receive a short-term capital loss, perhaps to net the loss against any capital gain, to diversify, or at least to cover any additional taxes that you will owe with your tax return for the spread at exercise or the value at vesting.
Alert: When you're selling company stock at a loss to net against gains, be careful about the wash sale rule if you intend to buy company stock again soon. Wait at least 30 days before repurchasing. However, be aware that the rule applies only after sales of stock at a loss. You can sell appreciated stock for a gain and soon repurchase it without wash sale problems.
Alternatively, your stock price substantially increased, hitting your targets earlier than you expected. Now you may want to sell before the one-year mark because you are concerned that your stock has peaked or that tax rates will rise, or because you are worried about overconcentration in company stock. However, you may not want to pay short-term capital gains rates (i.e. the same rates as those for ordinary income). Check whether you have capital-loss carry-forwards from last year or short-term losses from this year that you can net against these gains. This is a good time to use up these losses against your short-term gains, which can also be created from sales of ESPP shares. (See the related FAQ on netting capital losses against capital gains.)
8. You are deciding now whether to exercise and hold ISOs. You may want to see how much of a cushion you have in exercising ISOs before you trigger the AMT. That cushion is now bigger because of the changes in the AMT income exemption amounts and phaseout points under the TCJA. This type of analysis is discussed in another FAQ on this website. Do a multi-year analysis to determine whether you can avoid triggering AMT by exercising one portion of your ISOs this year and another portion next year. The combination of a low stock price and the tax changes introduced last year by the TCJA could make this a good year for an exercise-and-hold strategy with ISOs. Assuming you hold the ISO stock for one year after exercise, all the appreciation at sale is taxed at long-term capital gains rates.
9. Your tax bracket is less than 22%. Your company must withhold taxes, either at the supplemental wage rate of 22% or (if it chooses) at your actual W-4 rate. If you want to exercise NQSOs in either December or January, exercising in December means you'll receive a refund for the excess withholding after you file your tax return (this assumes you do not have other taxable income, such as dividends and capital gains, that have no tax withholding). Otherwise, by exercising in January you must wait until your following year's return for the refund.
10. You want to donate stock or cash. The increase in the standard deduction under tax reform can make donations this year worth more when you're trying to itemize deductions. The end of the year is also a time when many people consider making gifts and donations of company stock, which can be made directly or through a foundation or donor-advised fund, as explained in FAQs on this topic. For company stock you own, once you understand the tax rules this is often a better approach than first selling the appreciated stock and then donating the cash.
Be sure the stock transfer is completed by December 31 to make it count for the current tax year. For electronic transfers from your brokerage account, the donation is recorded on the day it is received by the charity/foundation (not when you approve the transfer). With increased year-end activity at brokerage firms, plan year-end stock gifts early and have ongoing communications with your broker to ensure the transfer takes place.
11. You want to gift company stock to children, elderly parents, or other relatives. If you expect your company stock price to appreciate, now may be a good time to consider gifting stock or even setting up a grantor-retained annuity trust. Be aware of the annual limit on the value of stock gifts that prevents any reduction in your estate tax exemption and lifetime exemption from gift tax, as explained in another FAQ. The amount of the gift tax exemption for 2020 is $15,000 per recipient, or $30,000 per recipient if you split the gift with a spouse. For people with low incomes in the 10% and 12% tax brackets (e.g. elderly parents in retirement), the long-term capital gains rate is 0%, so they can sell gifted stock without paying tax on the gain.
However, this capital gains rate of 0% on low incomes is usually not available to help students. If you plan to gift stock to a child for educational expenses, be aware that under the kiddie tax the child's gains are taxed at the parents' marginal tax rate until the child turns 19, and will apply up to age 24 for a full-time student who is funding less than half of their own support. (For more in general about using stock grants to fund higher-education expenses, see Life Events: College Funding.)
For more on year-end moves with stock options, restricted stock, RSUs, and ESPPs, see the articles elsewhere in this section of the website.