One of the most commonly overlooked aspects of the year's end is planning around equity compensation for those who receive stakes in their company as part of their pay.
Equity compensation planning is part portfolio management, part tax planning, and part overall financial planning. Some of the tax planning will help get you in shape for this coming April, and some will set you up for the rest of 2021.
It’s a multistep process that can get complicated. It's planning that often is best done in consultation with an accountant and a financial advisor. But it will help you keep more of that compensation in your pocket and stay on track to meet your longer-term goals.
Create a Year-End Checklist for Equity Compensation A year-end compensation review can require pulling information from a number of sources. Here's a checklist of areas to review based on your particular circumstances:
- Holdings and grants of stock options, restricted stock/RSUs, and other company stock
- Exercises, vestings, and employee stock purchase plan purchases in the current year
- Scheduled vestings for the upcoming year, as well as salary contributions assigned to ESPP purchases
- Expected new grants in the year ahead
- Expiration dates for any outstanding stock options and deadlines for option exercises
- Trading windows, blackout periods, company ownership guidelines, and post-vest holding period requirements/opportunities
- Any estimated salary withholding adjustments needed for the year ahead in the Form W-4
You can find another helpful checklist here.
Review Your Inventory Start by taking inventory of your holdings, including RSUs, ESPPs, incentive stock options, nonqualified stock options, and any company stock holdings in taxable and retirement accounts. If it helps, create a spreadsheet for each equity grant with the amount of shares granted, strike price, exercise window, and vesting schedule associated with each equity grant.
As vesting is determined separately for each grant, it’s critical to know whether your schedule is time-based or performance-based. In addition, vesting can follow a so-called cliff schedule, where shares will typically vest in one big chunk after a specific number of years; this is known as a graded schedule, where shares vest in increments (that is, monthly, quarterly, or annually). Along with this, it’s important to understand information from your company about the terms and conditions that determine your ownership.
This exercise will help you identify your holdings and the cost basis of owned shares. This information is particularly useful when considering selling shares, and can usually be found in your equity grant document or online through your employer’s plan sponsor (such as Shareworks or Fidelity). Having this information in one place makes it significantly easier to manage tax bills, avoid losing shares to expiration, and help determine the percentage of your portfolio and net worth that’s tied to your employer. More broadly, taking inventory of your holdings will help you integrate your company stock holdings into the bigger picture: your financial plan.
Tax Planning and Income Shifting Identifying the cost basis of owned shares is key to maximizing year-end tax planning. Stock compensation and tax planning go hand in hand, so it's in your best interest to keep a schedule of vested and unvested shares, as well as their expiration dates.
When you're granted multiple sets of options during employment, they usually have different exercise prices and exercise windows. When an you exercise them, you are usually given a choice between the different lots.
Because stock options can temporarily lose their value if the stock price dips below your exercise price, it's important to know which options make the most sense to exercise, if granted multiple lots. In most cases, you would want to avoid exercising shares that have lost value beyond your strike price. Request your company's open selling windows so you can exercise "in-the-money" options before expiration, if feasible.
Unlike stock options, which can trigger taxes when you decide to exercise, RSUs generally give you no control over the timing of when you take ownership, and therefore your tax exposure.
When restricted stock or RSUs vest, you own the stock outright and have taxable W-2 income for that calendar year, along with your other compensation income. Considering this, it might be a good idea to accurately time and shift other income around this restricted stock/RSU income to avoid getting bumped up into a higher bracket or triggering the Medicare surtax. For instance, making stock sales that generate losses to deduct or delaying NSO exercises, which would otherwise create a taxable event, are examples of shifting income. Essentially, the decision here is whether you should buy or sell more stock before year's end.
Moreover, if your employer allows, you can also consider choosing to be taxed at grant, instead of at vesting, by making what is called a Section 83(b) election. The election must be filed with your local IRS office within 30 days after your receipt of restricted stock or your stock option exercise.
Generally, you make the election by sending to the IRS office where you file your return the following information:
- Your name, address, and social security number
- The description of the shares (that is, X shares of X company)
- The date and taxable year you received the shares
- The fair market value of the shares at the time of grant
- The amount of money paid for the shares
- The amount to include in gross income (the FMV minus any money paid)
It helps to provide this information to your employer as well as attaching it to your tax returns when filing. Nonetheless, this action effectively accelerates income into the current year. Conversely, having a particular type of RSU from your company that lets you defer delivery of the shares will ultimately defer the taxes owed into future years. This, too, is company-specific and is only feasible if your employer allows it.
At any time when you are considering exercising stock options or selling stock at year's end, you want to understand your tax rates and any shortfall in withholding. In general, you want to:
- Keep your annual income under the thresholds for higher tax rates.
- Recognize income at times when your annual income and tax rates may be lower.
In other words, if your taxable income is $150,000, you are in the 22% federal tax bracket. If that is the case, you can recognize additional income of up to $51,050 before being bumped up into the 24% tax bracket.
Being that you can control the timing of stock sales and option exercises, and you know when restricted stock and RSUs will vest, multiyear planning is particularly valuable as it pertains to equity compensation.
Primarily, in your year-end planning for stock compensation, you are looking to identify methods to shift income between years so that you are paying less in taxes over your lifetime. The money you don't have to pay in taxes is money you can invest or spend responsibly, of course.
Be Aware of Tax Law Changes The Tax Cuts and Jobs Act, which occurred in 2018, had repercussions for compensation planning. So far, we've seen changes in the calculation of the Alternative Minimum Tax, as well as changes to the income tax rates and income ranges for each bracket, including a reduction in the top rate. Under the TCJA, the higher AMT income exemption amounts and much higher income point where the phaseout starts make it much less likely that ISOs will trigger the AMT.
If expect that the Biden presidency could potentially lead to higher tax rates for you in 2021, examine whether to accelerate income into this year. An excellent way to accomplish this is by exercising NSOs before the end of the year. This way, you’ll be recognizing income during a year where your tax liability could potentially be lower.
Stay Focused on the Big Picture Although it's an important consideration, taxes should never be the only reason for exercising options or selling vested shares--or waiting to do so at year's end. These decisions should be tackled within the framework of your overall investment objectives and personal goals. The real opportunity here is seeing how to align maximizing equity grants with an overall financial plan.
Samuel Deane is a financial advisor and CEO of Deane Wealth Management, an independent investment advisory firm for millennials in technology. Samuel specializes in comprehensive financial planning, equity compensation, and tax planning. The views expressed in this article do not necessarily reflect the views of Morningstar.