Tax Planning Isn't Just For Year-End

The critical time for tax planning is before the tax year ends. Of course, I think you should be thinking about tax planning all year, but year end is when we can adjust any portion of our strategy that may have gotten off track due to market behavior or rule changes. Let’s discuss those two things for 2023.

I know it is tempting to try to guess what a new year or new tax rules may bring and then speculate as part of a tax-planning strategy for your equity. But I encourage you to stick with the facts on the ground. A lot has happened in the last three years. The Executive Branch changed hands back in 2020, and in January of 2021, the Democrats gained control of the Senate, giving them very slim control of three branches of the federal government. Then, in late 2022, Republicans gained control of the House of Representatives so in 2023, we had divided government. That will continue through 2024 and given the legislative behavior of the House, it seems unlikely that any tax rules will be changed before 2025.

Even while the Democrats had control of government, when we saw plenty of legislation, none of it changed the overall structure of the tax rules. Tax brackets are slowly moving up, and various credits and deductions that are part of current tax law are phasing in (more on that below). There was a lot of talk about changes to the deduction for home mortgage interest, state and local tax deductions, and even the estate tax, but none of that happened.

Back in 2021, the American Rescue Plan Act, a substantial Covid-relief bill, passed through the process of reconciliation, without Republican support. This set the tone for the remainder of the 2021 session. In 2022, Congress passed the Inflation Reduction Act which included provisions to cut prescription drug costs, fund energy, climate and health care provisions and reduce the deficit by creating a 15% minimum corporate tax. Over at the White House, President Biden continued to issue executive orders to reverse and mitigate policies that were adopted by executive order in the previous administration. These orders concerned climate change, immigration law, tariffs, and environmental protection, not income taxes.

Tax Reform: A Summary And Look Forward To 2026

The Tax Cut & Jobs Act (TCJA), which took effect back in 2018, was the biggest change to the US tax laws since 1987. These five categories of tax rules summarize the biggest impacts that continue to apply to people with earned income and equity compensation:

• The top tax marginal bracket was lowered to 37% for single filers who, in 2023, have adjusted gross income (AGI) above $578,125 (above $693,750 for joint filers). Along with the rest of the rates, the statutory withholding rate for supplemental wage income, such as from stock compensation, was lowered to 22% (the rate is 37% for amounts in excess of $1 million during the tax year). These tax brackets will begin to sunset at the end of 2025.
• Long-term capital gains (and qualified dividend) rates remain at 20% for high earners who have, in 2023, adjusted gross income (AGI) of more than $492,300 (more than $553,850 for joint filers). The dividend and capital gain rates will not sunset at the end of 2025, but the tax brackets will adjust without additional legislation.
• The Medicare tax rate is still 1.45% for taxpayers with AGI up to $200,000 and 2.35% for single filers with AGI above $200,000 ($250,000 for joint filers).
• The TCJA raised the standard deduction, which in 2023 is $27,700 for joint filers and $13,850 for single filers. If you are over age 65 or blind, you also receive an additional $1,850 deduction in 2023. The personal exemption has been eliminated. Several previously itemizable deductions have been eliminated or capped, meaning that many tax filers will no longer have enough deductions to make itemization possible. This enlarged standard deduction will also sunset at the end of 2025 and will, without Congressional action beforehand, revert to the 2017 levels, indexed for inflation.
• The income exempted from the individual alternative minimum tax (AMT) has been raised, so many fewer taxpayers will pay it. In 2023, the AMT income exemption amounts are $126,500 for joint filers and $81,300 for single taxpayers.

Market Volatility: Opportunities And Risks

With all of the stock-price volatility in recent years, you should regularly monitor your employee equity holdings for the kind of tax-saving and portfolio-management opportunities that market moves can present.

I have said it before, but it bears repeating: Market participants' experiences over the last several decades may not be 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 since the continuing slow-motion recovery we experienced between 2010 and 2019. Even though the pace of recovery accelerated, as evidenced by record low unemployment and modestly rising wages, the Federal Reserve's interest-rate policies made it seem that it was concerned that the economy would experience slow going into 2020 and beyond. Fed policy continued to reflect it's belief that interest rate policy can keep inflation under control and mitigate recessions. 

When the pandemic hit, Fed policy was back to focusing on historically low interest rates while Congress flooded the economy with trillions of relief dollars. There was little agreement, however, as to what effect additional stimulus would have on financial markets. A new group of economists who adhere to Modern Monetary Theory (MMT) postulate that policy-makers have gotten it wrong and that the expanding deficits and debt that have characterized all but a few years of US fiscal policy since 1980 are not the source of our problems. They point to the ever-expanding federal budget and associated debt, driven mostly by defense spending, together with relatively modest inflation, as proof that too much spending isn't nearly as detrimental as too little.

Nevertheless, inflation accelerated in 2022 and is likely to persist at levels above the Federal Reserve’s target of 2% through the end of 2023. The Fed’s policy of raising short-term interest rates has had the effect of depressing equity markets and squeezing real estate values but it’s difficult to discern what to attribute to the lingering effects of the pandemic and what to give the Fed credit for. Equity markets have shown themselves to be remarkably resilient. Opinions are evenly split among market participants who think there will be a recession and those who do not. The Federal Reserve still maintains the option to further raise interest rates, but they have paused as of the time of this post.

International events, including the ongoing war in Ukraine and the Israel-Hamas war in Palestine are 2024 wild cards. The potential effect on energy prices from these conflicts isn’t manageable with interest rate policy. The resulting inflation and negative effect on world GDP from higher energy prices could be the catalysts to tip the world into a recession. Divided government in the US may stall military aid to Israel and Ukraine which could change the trajectory of these wars with potentially negative consequences for both regional stability and global energy prices.

So, like it or not, right now we live in a slow-growth, volatile world where we should paradoxically have both lower return expectations and, thanks to medical advancements, longer life spans. This is the biggest challenge for financial planning. I believe it is more important than ever to adhere to conservative principles of tax management and portfolio balance that we know make common sense in any market.

With all that as a background, for 2023 there is still time for tax planning before year-end. Below are some things to consider.

NQSOs And Restricted Stock: Little You Can Do

The spread between the exercise price and the market price of nonqualified stock options (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 this year, because an exercise will push your marginal income into the highest rate, you may want to consider straddling years for your NQSO exercise to take the compensation income in the lower-tax year, going just up to the 37% threshold but not over it.

With restricted stock or restricted stock units, you usually have no flexibility in choosing the tax year, as the vesting date is set, but you may be able to defer the tax consequence by designating the vesting to a deferred compensation plan. Beware of building up a concentration of company stock in your deferred comp plan, though. Market drops can cost as much or more than tax bills.

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.

A lot of temporary tax breaks were enacted in 2021. Almost all of them expired in 2022. A useful one that remains is the Lifetime Learning Credit, which is worth 20% of the first $10,000 of qualified education expenses. The value of the LLC is also a credit that is limited by your income. For 2023, you can claim up to the full credit if your Modified Adjusted Gross Income (MAGI) is $80,000 or less for single filers and $160,000 or less for joint filers. A phaseout of the benefit means that you won't be able to claim the LLC once your MAGI reaches $90,000 for single filers or $180,000 for joint filers.

If you can postpone a planned NQSO exercise into 2024 and, by doing so, keep yourself under these thresholds, you can claim the tax-associated credits.

For NQSO-holders who have already maxed out their Social Security tax by earning over $160,200 in 2023 ($168,600 in 2024), 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. Remember that, as stated above, the Medicare tax is 2.35% for single taxpayers earning over $200,000 ($250,000 for married joint filers), and a Medicare surtax of 3.8% on investment income also applies to those same taxpayers.

Planning Ideas

Special year-end tax moves for option holders generally apply more to incentive stock options (ISOs), discussed below. With these thoughts in mind, add the following items to your planning between now and the end of the year. 

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 the following June, you will miss out on a gain of $20 per share. This is one reason why you should almost never make exercise or sale decisions based solely on tax considerations.

You should always base exercise and stock-sale 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, but you'll never build wealth 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.

Be Sure You Can Pay Your Taxes

Always double-check that you will have the money to pay your taxes. You may owe some income tax beyond what your company withheld at exercise or at vesting with restricted stock/RSUs. When you exercise NQSOs or when your restricted stock/RSU grants vest, your company withholds federal, state, and Social Security taxes.

Potential Withholding Shortfall

Most companies withhold federal tax at only the minimum required federal supplemental income withholding flat rate of 22% (37% for total yearly amounts of supplemental income in excess of $1 million). If you are in a higher tax bracket, you may owe the additional amount with your tax return (or through estimated taxes), unless you're fortunate enough to have made more than $1 million in supplemental income.

For nonemployees (e.g. consultants or contractors), the company might not have withheld taxes at all, in which case you should expect to receive an IRS Form 1099-NEC 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 pay estimated taxes and/or sell more stock this year, but at least you will be confident of your ability to pay taxes.

Sell Losers

Despite the long market recovery, because of volatility you may still have some shares whose prices are significantly below what you paid for them. Consider selling stocks that have lost value, 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.

Know The Rules On Loss Deductions

Consider stock sales that generate losses to deduct. If stock acquired from an option exercise or restricted stock/RSU vesting is now worth $5,000 less, the sale will generate a $5,000 capital loss. This may reduce your tax liability, but whether the deduction is immediately usable depends on the rest of your tax situation, including the gains and losses from other stock sales and loss carryforwards from prior years.

The 2018 tax law didn't change capital gains rules. 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. If it turns out that your tax rates are eventually higher in 2024 and beyond, consider one "benefit" you may not have thought about: higher rates make loss carryforwards more valuable to offset against ordinary income. Current tax rules allow write-offs against ordinary income up to $3,000. In the top 37% bracket, the offset will be worth $1,110.

If you think your company's stock is overvalued or you are overconcentrated in it, consider taking capital gains by year-end to use up losses from this year or losses carried forward from prior years. You should pay close attention, as we approach year-end, for an opportunity to sell at a loss those appreciated shares along with an offsetting number of shares from previous vesting and exercises. This will help you diversify, raise cash, and position yourself for what may come.

Sell If You Need Money

Even with the tax changes, your stock gain at sale is taxed at the long-term capital gains rate of only 15% or 20% (depending on your adjusted gross income) when you have held the shares for more than one year. Capital gains are still preferable to ordinary income.

Should you need money to pay for your child's college tuition in January, sell stock. While we're (again) on the subject of college tuition, the American Opportunity higher-education credit (AOC)—which offers up to $2,500 annually per student for four years of college and covers tuition, room, board, and books—is still available. 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.

Alert: You cannot use the AOC and the previously mentioned LLC for the same student in your household, but the two credits can be mixed and matched for individual dependents.

Consider Gifting Stock To Relatives In Low Tax Brackets

In 2023 you may make annual gifts of $17,000 ($34,000 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. Financial planners often advise 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. High-net-worth individuals should consider a grantor-retained annuity trust for their company stock.

The long-term capital gains tax rate on people in the 12% tax bracket is 0%. If you have adult children, who file their own tax returns and whose income is likely to be in the 12% tax bracket in 2023, they will pay 0% tax on long-term capital gains that don't cause their income to rise to the next bracket. Consider a gift of appreciated shares to them up to the annual gift limit before year-end.

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.

Retirement Planning: It's Not Too Soon

Equity compensation exercise strategies should, ideally, be coordinated with your retirement planning (for thoughts on how best to do this, read my blog post Retirement Planning With Stock Compensation). It's not too soon to plan for future years or too late to make a retirement plan contribution for the previous year.

Even if you are covered by a retirement plan at work, such as a 401(k), you can still take a full IRA deduction for 2023 if your modified AGI is less than $73,000 ($116,000 for married joint filers). A partial deduction is allowed until your AGI reaches $83,000 ($136,000 for married joint filers).

For the 2023 tax year, the contribution limits for a Roth IRA are $6,500 for a person under 50, and $7,500 for a person who is 50 or older before the end of the year. To be eligible for maximum contributions in 2023, married joint filers must have MAGI of $218,000 or less, and single filers must have MAGI of $138,000 or less. The phaseout range for partial contributions extends from there up to an income ceiling of $228,000 for married joint filers and up to $153,000 for single filers. Beyond that point, contributions are not allowed.

Alert: Up to the filing deadline of your 2023 tax return in April 2024, you can make Roth IRA contributions that still count for the 2023 tax year. (IRS Publication 590-A has more information.)

If you are already contributing the maximum to your 401(k) at work or if you have additional compensation income this year from your stock option exercise or restricted stock/RSU vesting, making you ineligible to fund a Roth IRA or deductible IRA, you may want to consider funding a nondeductible IRA with the expectation that it can be converted to a Roth later. 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). Income from your stock compensation can help you pay this additional tax.

Year-End Planning For Incentive Stock Options

Year-end planning is especially important for anyone who has exercised incentive stock options (ISOs) during the year. Unlike nonqualified stock options (NQSOs), ISOs are quite often exercised with the intention of holding the stock to qualify it for long-term capital gains treatment on the full gain over the exercise price.

You may be holding ISO stock because of the opportunity presented by a dramatic drop in stock prices this year or any one of the last several volatile years. Alert employees may have jumped at the chance to exercise ISO grants that were made when the company's stock price was abnormally low (see my blog post on Down and Volatile-Market Strategies). Other recipients of ISOs are employees of companies that went through an IPO this year or last (see my post onFinancial Planning at IPO Companies). It may be time to decide whether the moment is right to take long-term gains on ISO shares you still have or use the current down market to your advantage.

Any dramatic drop in stock price should make people who exercised ISOs in 2023 and before carefully examine their strategy. Some of those shares are trading at prices below where they were exercised; others have fallen from their highs but still trade above their exercise price. Both situations could, nevertheless, leave you with an alternative minimum tax (AMT) conundrum.

The down market may entice you to exercise ISOs that you previously avoided because of the potentially large AMT you'd owe, or lead you to eliminate the AMT by selling ISO stock before year-end that you acquired from exercises when the market price was higher. Either way, let's examine some of your planning choices.

Determine Your Alternative Minimum Tax (AMT) Opportunity

Under the Tax Cut and Jobs Act (TCJA), the alternative minimum tax (AMT) calculation dramatically changed. While the AMT didn't go away, the rules are now a bit more friendly to taxpayers than they were before 2018.

Impact Of Tax Reform On AMT

Under the current tax rules, only truly high-income folks see their exemptions phased out, while middle-income taxpayers benefit from full exemptions.

2023 AMT income exemption amounts, phaseouts, and rate thresholds

Are You Getting An AMT Credit For Christmas?

The enlarged AMT exemption and higher exemption phaseouts benefit people who had to pay the AMT in prior years. These taxpayers generated an AMT credit when they exercised ISOs and held the associated stock with the expectation that they would get long-term capital gains tax treatment on the full appreciation at the eventual sale of the shares.

Named the Minimum Tax Credit (MTC) back in 1986 when it was adopted, the credit provided for a carryforward that was expected to be used in future years. But it turned out that some of these taxpayers couldn't ever use their MTC. Due to the previously low exemptions and equally low phaseouts, they continued to be subject to the AMT, year after year, because of high income, big deductions, and/or additional ISO exercises.

Under the current law, lots of taxpayers will probably be able to use up most of their MTC because of the higher AMT exemption and phaseout point. A much larger gap between the household's regular tax and AMT lets them claim their credit carryforwards. It is unclear whether Congress really intended to give these taxpayers big AMT relief in the 2018 bill, but it's turned out to be an annual Christmas bonus for some highly compensated executives over the last few years.

Calculate AMT Cushion

Big stock-price drops mean more shares can potentially be exercised without triggering the AMT. If you have not already exercised any ISOs this year, ask your accountant to determine your AMT spread and cushion. This spread is the difference between your ordinary tax and your AMT obligation. Even though itemized deductions have been reduced under the new tax law, the spread at ISO exercise can be large enough to trigger the AMT. If you calculate that your 2023 ordinary tax is greater than your AMT, you have an opportunity to exercise some more ISOs without owing any additional tax.

Example: Your accountant says that your ordinary tax is $70,000 and your AMT is $60,000, meaning you have a $10,000 AMT spread. You can generate an additional $10,000 of AMT without paying any extra taxes. Assuming you are in the 28% AMT bracket, you may be able to exercise ISOs with a spread of $35,714 without paying any additional tax (this generates $9,999 of AMT). The exercise begins your holding period to qualify for long-term capital gains. As a result, you will be able to sell the stock after one year from exercise (two years from grant) and pay only the lower long-term capital gains tax on the full increase over your exercise price.

This may not be to your advantage if you currently have an AMT credit carryforward from last year. (Of course, you should confirm any tax calculations with your accountant and other advisors.) However, the AMT spread sometimes provides an opportunity to generate income without generating additional tax.

Decide About ISO Stock That Has Lost Value Since Exercise

The beginning of the year is often the time when equity-holders decide to exercise ISOs to get the long-term capital gains clock ticking. If you exercised and held ISOs this year and the stock has dropped in value since exercise, you have to make an important decision. Should you sell the stock before the end of the year of exercise to eliminate the AMT, or should you simply sit still and hope the stock price will recover?

Example: You have an exercise price of $10. You exercised your option on January 15 of this year, when the stock had a value of $50. You generated $40 per share of alternative minimum taxable income (AMTI). If you are in the 28% AMT bracket, you will owe $11.20 per share of AMT (with an AMT credit to use in future years). You plan to hold the stock until January 16 of the next year. You intend to sell the stock and pay only long-term capital gains on the profit.

However, on December 1 the stock is trading at only $20 per share. If you sell the stock, your tax calculation changes substantially: selling the stock is a disqualifying disposition, and the gain is taxed as ordinary income. The gain, though, is limited to the difference between your exercise price ($10) and sale price ($20). You will have only $10 per share of ordinary income. If you are in the 37% top federal tax bracket you will owe $3.70 per share. The original AMT is simply eliminated.

You must make a decision. If you sell in December, you will have to pay only $3.70 of tax. If you wait until January of the following year, you will have to pay the AMT of $11.20. You will get a credit for some of the AMT, but it may not be easily usable. Therefore, you may want to sell in December to eliminate the AMT liability.

Of course, the numbers all change for the better if you do not sell in December and the stock recovers to $50 per share in the following year. Although you will still owe the $11.20 of AMT, you will make a lot more money by selling at $50 instead of at $20 per share. In this situation, you should consider selling if you are concerned that the stock price may not appreciate, or if you do not have the funds to pay the AMT. If you have the money to pay the AMT and expect the stock to appreciate, waiting to sell may still be worth considering

Evaluate Your Own ISO Situation

It's important to determine:

• your AMT liability without a sale
• your ordinary tax liability if you sell
• how you will pay your AMT if you don't sell

In addition, remember to factor in your confidence in the future value of your stock. If you think the stock is going to appreciate substantially, waiting is your best choice. Exercising ISOs early in the year to start the 12-month holding period gives you more time to watch the stock so that you can decide whether a disqualifying disposition is prudent.

Consider Year-End Gifts Of Appreciated ISO Stock

The long-term capital gains tax rate on people in the 12% tax bracket is 0%. You may have adult children, retired parents, or other lower-income family members who file their own tax returns and whose income is likely to be in the 12% tax bracket. If so, they will pay the 0% tax rate on any long-term capital gains that don't raise their income to the next bracket. Consider giving these family members a gift of appreciated shares before year-end up to the annual gift limit ($16,000 per person, per gift). Gifting highly appreciated ISO shares can also be a wise way to remove value from your taxable estate, though you should be aware of the kiddie tax rules and the caution about gifting ISO stock discussed below.

Beware Of Gifting ISO Stock Too Early

Don't get carried away by the holiday spirit! Gifting stock that is generated from the exercise of an ISO is considered a disposition. If you have not met the required holding periods and you gift the stock, the gain at exercise is taxed as ordinary income in what is called a disqualifying disposition. This includes gifts to charities, family members, or others. Therefore, you may not want to gift the stock until you have met the ISO holding periods. Other planning issues arise if you triggered the alternative minimum tax when you exercised ISOs to acquire the shares that you later gifted

* All investing involves risk, including the possible loss of principal.  There is no assurance that any investment strategy will be successful. The return and principal value of stocks fluctuate with changes in market conditions. Shares when sold may be worth more or less than their original cost. Past performance does not guarantee future results.  Investors should consider their financial ability to continue to purchase through periods of low price levels.

This blog is designed to provide accurate and authoritative information on the subjects covered. It is not, however, intended to provide specific legal, tax, or other professional advice. For specific professional assistance, the services of an appropriate professional should be sought.

These examples mentioned above are hypothetical only, and do not represent the actual performance of any particular investments.  Investments in securities do not offer a fixed rate of return.  Principal, yield and/or share price will fluctuate with changes in market conditions and when sold or redeemed, you may receive more or less than originally invested.