Broker Check
Year-End Planning

Year-End Planning

| November 11, 2019
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Every year in February, after the W-2s and 1099s have arrived, we get tax-planning calls. Of course, by then it's too late for previous year planning. The time for tax planning is before the year ends. This year, we are working with a new tax law so you could be forgiven for not being too sure of what made the most sense for 2018 but going forward, there are plenty of planning ideas to discuss:

The Tax Cut & Jobs Act of 2017 is the biggest change to tax laws since 1987. These five categories of tax rules summarize the biggest impacts for people with earned income and equity compensation:

  • The top tax marginal bracket was lowered to 37% for single filers who, in 2019, have adjusted gross income (AGI) above $510,301 (above $612,351 for joint filers). Along with the rest of the rates, the statutory withholding rate for supplemental wage income, such as from stock compensation, has been lowered to 22% (the rate is 37% for amounts in excess of $1 million during the tax year).
  • Long-term capital gains (and qualified dividend) rates remain at 20% for high earners who have, in 2019, adjusted gross income (AGI) of more than $434,550 (more than $488,850 for joint filers).
  • 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 standard deduction for joint filers was  raised to $24,000 by the new tax law. For 2019, the standard deduction is inflation adjusted to $24,000. If you are over age 65 or blind, you also receive an additional $1,300 deduction. The personal exemption has been eliminated. Several previously itemizeable deductions have been eliminated or capped, meaning that many tax filers will no longer have enough deductions to make itemization possible.
  • The income exempted from the individual alternative minimum tax (AMT) has been raised to $111,700 for joint filers ($71,700 for single taxpayers), so many fewer taxpayers will pay it.

Market Volatility: Opportunities and Risks

2018 turned out to be another volatile year for equities. Back in 2008 and early 2009, the steepest market decline in 75 years wiped out many people's retirement savings, dropped many stock plan participants' options out of the money, and significantly reduced the value of rewards deferred or granted during the prior several years. The rebound through most of 2014 and 2015 partly reversed some of those losses, and for some people, the rally following the presidential election at the end of 2016 produced significant short-term gains in grants received during those down years. October of 2018 saw a dramatic drop in equities, especially those in the technology sector. Between now and the end of the year, it is important that you once again carefully examine your employee equity holdings for the kind of tax-saving and portfolio-management opportunities that volatility can present.

Many market participants' experience over the last few 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 in the continuing slow-motion recovery we have experienced over the past decade. Even though the pace of recovery appears to have accelerated since the beginning of 2018 as evidenced by record low unemployment and modestly rising wages, the Federal Reserve's interest-rate policies make it seem that it has concerns that the economy may experience slow  going into 2020 and beyond.

Now that more than ten years have elapsed since the 2008-2009 credit crunch and market crash, past performance numbers represented in funds, indexes, and other market measures are going to look very attractive. Don't be fooled into believing that a recovery from historically volatile lows to where we are now is a pattern that will be perpetuated indefinitely. We have already experienced the longest post WWII recovery ever so financial-planning assumptions based on data from the post-oil-embargo 1970s through the beginning of the 21st century may not translate to this environment. Lower return expectations and longer life spans will make it more important than ever to adhere to conservative principles of tax management and portfolio balance that we know make common sense in any market. We discuss these below.

NQSOs and Restricted Stock: There is Still Little Tax Planning Available

The spread between the exercise price and the market price of 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 Incentive Stock Options (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.


Maxed Out On Social Security?

For NQSO-holders who have already maxed out their Social Security tax by earning over $132,900 in 2019 ($137,700 in 2020), 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 ISOs, which I’ll discuss a little later. With these thoughts in mind, add the following items to your planning between now and the end of the year. (Note that the tax issues and treatment discussed here are similar for stock appreciation rights (SARs).

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 February, you will miss out on a gain of $20 per share. You should almost never make exercise or sale decisions based solely on tax considerations from an advisor. No advisors know with certainty what tax rates will be in the future.

You should always base exercise 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 with your equity compensation shares. 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.

Make sure you can pay your taxes. Always double-check that you will have the money to pay your taxes. If you exercised NQSOs, you may owe some income tax beyond what your company withheld at exercise. When you exercise an NQSO, your company withholds federal, state, and Social Security taxes. However, companies withhold federal tax at the previously mentioned statutorily required federal supplemental income withholding rate of 22% (37% for total yearly amounts of supplemental income in excess of $1 million). Similar withholding rates apply to the value of restricted stock at vesting. If you are in the 32% or higher tax bracket, you may owe additional tax with your return.

In addition, if you were not an employee of the company when you exercised NQSOs (e.g. a consultant or contractor), the company might not have withheld taxes at all. Instead, it might have just given you an IRS Form 1099-MISC that reports the income. Ask your accountant 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, but at least you will be confident of having cash on hand to pay taxes.

Sell losers. Despite the market recovery, not every company’s stock rose to new highs. You may still have some shares whose prices are below what you paid for them, perhaps substantially. Consider selling stocks that have lost value since purchase, 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. Sell if you can deduct the loss. 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 the amount of the deduction depends on the rest of your tax situation, including the gains and losses from other stock sales and loss carryforwards from prior years.

The new 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 2019 and beyond, consider one "benefit" you may not have thought about: higher rates make loss carry-forwards more valuable if they are used to offset 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.

American investors lost $5 trillion in the market decline of 2008. If you are like many stockholders, you might still be carrying forward market losses. Consider taking capital gains by year-end to use them up if you think your company's stock is overvalued or you are over-concentrated in it. Some people whose restricted stock and restricted stock units vested in 2007 and 2008 may still own shares at a tax basis that is above today's market price, while shares that vested in 2009, early in that year, are up substantially. Pay close attention, as we approach year-end, for an opportunity to sell the appreciated shares and an offsetting amount of shares from previous vestings, at a loss, in order to diversify, raise cash, and position ourselves 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 yearly 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 university tuition in January, sell stock. Although you might think that the market is poised to rise again, don't wait. If it drops instead, you may not be able to pay the tuition costs. Always keep your short-term cash needs out of stocks so that you can ride through any short- or long-term drops in the market. While we're on the subject of college tuition, the American Opportunity higher-education credit which offers up to $2,500 annually per student for four years of college and covers tuition, room, board, and books, was kept unchanged in the new tax law. The credit begins to phase out at $90,000 of AGI ($180,000 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.

Consider gifting stock to relatives in low tax brackets.You may make annual gifts of $15,000 ($30,000 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 advisors often tell 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.

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 2018, they will pay 0% tax on long-term capital gains that don’t cause their income to rise to the next bracket. Consider an appreciated shares gift to them of up to the annual gift limit before year-end. Gifting highly appreciated ISO or vested restricted shares you held on to can be a wise way to remove value from your taxable estate and will allow the lower income recipient to sell 366 days after your gift and qualify for the 0% rate.

Alert: The "kiddie tax" (i.e. your tax rates, not your children's) got a little bit easier under the new tax law. It 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:

Equity compensation exercise strategies should, ideally, be coordinated with your retirement planning. 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, such as a 401(k), at work, you can still take a full IRA deduction for 2019 if your modified AGI is less than $64,000 ($103,000 for married joint filers). A partial deduction is allowed until your AGI reaches $74,000 ($123,000 for married joint filers).

For the 2019 tax year, the contribution limits for a Roth IRA are $6,000 for a person under 50, and $7,000 for a person who is 50 or older before the end of the year. To be eligible for maximum contributions in 2019, married joint filers must have MAGI of $193,000 or less, and single filers must have MAGI of $122,000 or less. The phase-out range for partial contributions extends from there up to an income ceiling of $203,000 for married joint filers and up to $137,000 for single filers. Beyond that point, contributions are not allowed.

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 non-deductible 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 ISOs

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. The most likely recipient of ISOs in today’s market are employees of companies that went through an IPO this year or last, as this activity dramatically ramped up over the last few years.

This year's volatility may have you thinking that a market top has been reached. If your confidence about your company's outlook has risen, you may be thinking about exercising and holding now. The market's performance since the credit crunch may cause you to consider locking in your gains on options you exercised earlier. Either way, below are some things you should think about if you have ISOs or have exercised ISOs in the past:

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

For both single and joint filers, the 26% AMT rate rises to 28% when AMT income in 2019 exceeds $194,800 ($97,400 for those who are married but filing separately). The TCJA also increased the exemption amounts and phase-out thresholds that you are allowed to subtract when calculating your AMT income. The exemption is phased out when your AMT income surpasses the applicable threshold. For 2019, the exemptions are $111,700 for married joint-filing couples and $71,700 for single filers. The phase-out thresholds are $1,020,600 for joint filers and $510,300 for single filers. The AMT exemption is reduced by 25% of the excess of AMT income over the applicable phase-out threshold. So under the current tax rules, only truly high-income folks see their exemptions phased out, while middle-income taxpayers benefit from full exemptions.

AMT Credit

The enlarged AMT exemption and higher exemption phase outs will benefit people who had to pay the AMT in prior years. These taxpayers generated a minimum tax credit (MTC) 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 when they eventually sold. It turns out that some of these people couldn't ever use their MTC. They continued to be subject to the AMT, year after year, because of high income, big deductions and/or additional ISO exercises. Now they will probably be able to use up most of their MTC because of the higher AMT exemption and phase-out 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, but it could be an unexpected Christmas bonus for some highly compensated executives.

No matter what the rate or level of exemption is, the AMT may present an opportunity. If you have not already exercised any ISOs this year, ask your accountant to determine your AMT spread. 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 2019 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 additional taxes. Assuming you are in the 28% AMT bracket, you may be able to exercise ISOs with a spread of $35,700 without paying any additional tax (this generates $9,996 of AMT income). 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 carry-forward 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.

Make a decision about ISO stock that has lost value since exercise. As I observed before, not every stock is higher today than it was earlier in the year. 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 to eliminate the AMT, or should you simply sit still and hope the stock 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 at least 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.

Make sure to 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 of 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.

Beware of gifting ISO stock too early. Finally, don't get carried away by the holiday spirit! Gifting stock that is generated from the exercise of an ISO is also considered a disqualifying disposition. If you have not met the required holding periods and you gift the stock, the gain at exercise is taxed as ordinary income. This includes gifts to charities, family members, or others. Therefore, you may not want to gift the stock until you have met the holding period.

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