Daniel Zajac, CFP®

Incentive Stock Options and Executive Compensation

Wealth Accumulation

9 Year-End Planning Tips for Your Equity Compensation

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You might not give much thought to the equity compensation you receive throughout the year (until you’re forced to take action with it). But even if you do have a long-term plan in mind, it’s smart to pause periodically and review the overall strategy.

The end of the year is a prime opportunity for this review, and also provides a chance to check in and recall any decisions made during the calendar year. Not only will this allow you to stay abreast of your current situation, it may be the right time to implement decisions that could have a material impact on your investments, income tax, and cash flow in this year or the next.

Here are 9 considerations to keep in mind during a year-end review of your equity compensation.

1 – Take Stock of What You Have (and What You Have Done)

The end of the year is a good time to take an inventory of your equity compensation package. This may start with a simple review of what’s included.

Do you have incentive stock options, non-qualified stock options, restricted stock units, an employee stock purchase plan, or stock appreciation rights? Know what you have and make sure you have a basic understanding of the rules and important information around each type of equity comp in your package.

Next, consider a more detailed review of individual grants. Individual grant review can provide you more granular detail such as vesting dates, expiration dates, exercise price, and other key information.

Grant information may also lead you to explore your previous exercise history, any AMT that might be due or any AMT credits coming back to you, vesting history, and current stock owned outright.

This year-end process is about understanding what you have, what you can do with it, when you can do something, and what planning opportunities may arise. You can only make sound decisions around properly coordinating your equity compensation with your financial plan if you know what you have and what actions you’ve already taken.

2 – Exercise Incentive Stock Options Shares Up to the AMT Crossover Point

If you hold in-the-money incentive stock options and do not expect to owe alternative minimum tax when projecting your tax return, you may want to consider exercising your ISOs so that the bargain element is just enough that your tentative minimum tax is equal to your regular minimum tax.

The net result of this transaction means that you will exercise and hold just enough ISOs that you will not owe AMT.

One benefit of this AMT crossover strategy is that you begin the holding period requirements to achieve a qualifying disposition of your exercised-and-held ISOs. A second benefit is that you do so without the commonly-required cash outlay required if you exercised ISOs to cover the AMT.

Keep in mind there is risk associated with this strategy. Even though you may not owe AMT on this type of exercise, you will be required to pay for the exercise cost of the shares themselves. This requires you to put cash (or its equivalent) into the transaction — and in theory, you could lose that money if the stock price drops in value.

You should also be aware that this strategy may or may not make a material impact on how many ISO shares you have exercised and held, versus how many you control. If you have a lot of ISOs, this may only allow you to exercise a few of them, but it does provide the benefit of beginning the holding period for a qualifying disposition.

3 – Sell Incentive Stock Option Shares That Are Down in Value

Year-end is a good time to review the current value of any incentive stock option shares that you exercised and held early in the calendar year.

If the prevailing fair market value of the stock is lower than fair market value on the date you exercised, you may want to evaluate the opportunity to sell these shares and intentionally create a disqualifying disposition.

When you exercise and hold, the bargain element is a determining factor in whether or not you owe AMT. If the bargain element is big, it may lead to a large AMT bill.

But if the stock price drops between the time you exercise and the end of the year, you may find yourself wishing that you hadn’t exercised because the cost of the AMT is going to unaffordable (or, at the very least, undesirable).

Assuming this is the case, selling the shares that were exercised and held early in the calendar year will “undo” the AMT preference item requirement and eliminate your AMT bill. Selling in this scenario leads to a disqualifying disposition, and you will likely need to pay ordinary income tax on the spread between the exercise price and the final sales price of the stock.

While paying ordinary income may not seem as desirable as paying long term capital gains, a falling stock price post-exercise and the ability to undo AMT might create a situation where it could be just the right opportunity for bigger-picture income tax planning and cash flow planning.

4 – Review the Possibility of Accelerating an AMT Credit

The alternative minimum tax is a bit like a prepayment of expected income tax on your exercised and held incentive stock options. But this prepayment often requires you to pay more in taxes than you otherwise would have, leading to a net cash flow.

Eventually, when you sell your ISO shares in a qualifying disposition, you might have the opportunity to receive your AMT back in the form of a credit.

If you have qualifying ISO shares, the end of the year could be a good time to evaluate whether or not you should sell those shares. Selling the shares may not only result in reduced position in company stock and a positive cash inflow from the proceeds, it may result in receiving your AMT credit back sooner rather than later.

5 – Review Your Strategy for Vested Restricted Stock and Exercised Non-Qualified Stock Options

Generally speaking, when restricted stock units (or awards) vest and you exercise non-qualified stock options, each type of compensation is taxed as ordinary income and paid to you via a cashless transaction.

A cashless transaction means that the value of the unit or option is paid in company stock, after subtracting some amount for income tax withholding (usually 22%). But you don’t need to keep the shares simply because the value of the equity compensation was paid to you in shares.

The end of the year is a good time to evaluate whether or not you should keep those shares, or sell them.

If you want to limit your concentrated position in a single stock, selling shares obtained during the calendar year may be an attractive strategy. If the prevailing market price is near the price at which the shares vested or were exercised, the additional tax implications to sell may be minimal as you only need to pay capital gains (loss) on the amount in excess of the cost basis.

From a cash flow standpoint, this may mean you will receive nearly the full proceeds of the sale. You can then use these proceeds to address some of your other financial planning goals and objectives.

6 – Consider Liquidating ESPP Shares

Much like RSU and NQSOs, you should evaluate your ESPP at year-end. Participation in a good ESPP that offers a discount on the purchase price and a lookback provision can be a good reason to participate in the plan to your fullest capability.

Retaining company stock in an effort to achieve a qualifying disposition and preferential tax treatment, on the other hand, may or may not be as attractive as it seems. To do so, you have to hold the ESPP shares for at least a full year after receiving them, which subjects you to the market risk of owning a single stock.

Consider your ESPP strategy and how much you currently participate. Do you need to make adjustments to bring that strategy in line with your overall financial plan or risk tolerance? Should you retain or sell your ESPP shares to accomplish that?

These are important questions to ask when reviewing your current use of an ESPP.

7 – Evaluate the Opportunity to Accelerate Income into This Calendar Year

If you find yourself in a low-income tax year, or expect to be in a significantly higher tax bracket next year, it may make sense to accelerate some of your income into this calendar year. Generally speaking, accelerating income can be accomplished in two ways:

First, you can accelerate income by exercising non-qualified stock options.

When you exercise NQSOs, the bargain element is treated as compensation income in the year of exercise. Another consideration may be to exercise and sell your ISO as a disqualifying disposition. This transaction may also have the impact of accelerating ordinary income into this calendar year.

A second option may be to sell previously held stock.

If you hold shares that have experienced a long-term capital gains outright, selling those shares may mean you are able to capture the gains at a preferential tax treatment. If your income is low enough, your long-term capital gains may not be taxed at all.

8 – Evaluate Your Projected Income Tax Due (and See If You Might Get a Refund)

In a year that you have restricted stock that vests and/or stock options that you exercised, projecting and paying income tax can be complicated. Year-end can be a good time to project your tax return to see if you have paid enough tax to cover your tax bill.

To do so, you might want to consider a few things:

First, you should calculate what you expect to owe in income tax for the year. This may include income tax from RSUs and NQSOs that will be subject to ordinary income tax treatment, or from AMT and/or capital gains taxes more commonly associated with ISOs.

Once you know what your tax bill is projected to be, you can determine if you have withheld enough via payroll deductions and estimated tax payments to cover the projection.

Companies will often withhold income tax on RSUs and NQSOs at a statutory federal income tax rate of 22%. (With ISOs, you usually won’t have any money withheld from your paycheck.) This may or may not be enough to cover your total tax bill, so this is important to figure out even if your company already withheld some money from your salary.

If you feel as though you underpaid your income tax, you may want to make an estimated tax payment to cover the need, or set aside cash to pay the tax due when your return is prepared.

9 – Plan for Next Year

As part of a year-end review, you might want to evaluate whether or not you have RSUs that vest, stock options that are set to expire, or ISOs that will meet the qualifying disposition standard.

If you understand what is expected and project a future tax return, it may lead to planning opportunities such as coordinating equity compensation with other employee benefits like a nonqualified deferred compensation plan, or an increase in your current 401(k) deferral rates.

This may also lead to opportunities around cash flow planning. If you expect a large sale of stock or a large vesting of RSUs, you want to plan for what you will do with the proceeds. This is where proactive financial planning may come in to play.

If You Want to Make the Most of Your Equity Comp, Plan a Year-End Review

Year-end planning for equity compensation is more than an arbitrary timeline at which to review your needs. It’s a time when income tax, cash flow, and investment risk can all be materially impacted by decisions (or non-decisions) prior to the close of business on December 31.

While the list above is not a complete list of planning considerations, it does provide a primer in to some of the things you may want to consider.

Keep in mind, however, that each one of these topics can be complicated, and by combining several into a coherent plan may require the skills of an accountant, a financial planner, an investment guru, and most important your personal goals and objectives.

The content herein is for illustrative purposes only and does not attempt to predict actual results of any particular investment.   Diversification does not guarantee a profit or protect against a loss.  None of the information in this document should be considered as tax advice.  You should consult your tax advisor for information concerning your individual situation.  Tax services are not offered through, or supervised by, The Lincoln Investment Companies.

5 Steps to Managing Concentrated Equity in Company Stock and Stock Options

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Concentrated equity, also known as owning a large position in one company stock, can exist in many forms. One form of concentrated equity may be the result of working for an employer who has issued stock ownership via restricted stock and stock options.

These types of stock ownership and stock rights allow an employee to participate in the growth of the company via an appreciating stock price. If you are issued many shares or are issued shares of a company that has experienced meteoric growth, you may find yourself with a concentrated equity position rather quickly.

So what do you do if you find yourself with a large position of one company stock? Possibly seek help. Because managing concentrated equity positions may prove difficult. In fact, managing concentrated equity may require complex strategies and a deep understanding of plan rules, tax rules, selling restrictions, and overall portfolio impact.

With so many moving parts, it’s easy to understand why many owners of concentrated equity positions may feel overwhelmed. The combination of a large portion of wealth, a minimal understanding of the issues, and the fear of making a mistake can leave even the most sophisticated investor paralyzed.

Often you can start by taking stock of what you have.

Step 1 – What Do You Actually Own?

It’s not uncommon for a client to lack a full understanding of what they own. They know they own company stock in some form or fashion, but the details are lacking.

A first step is often to take inventory of what you actually own. Some common forms of company stock ownership and stock rights include the following:

  • Outright ownership of company stock
  • Company stock as part of an employee stock purchase plan (ESPP)
  • Restricted Stock Units or Awards
  • Incentive stock options
  • Non-qualified stock options
  • Shares in an Employee Stock Ownership Plan (ESOP)

It’s important to know exactly what is owned for many reasons. Primarily, it’s important because the rules and regulations governing each type of company stock ownership may be different. Different in terms of liquidity, accessibility, and tax.

Through this process it’s important to evaluate what has already occurred. For example, have you exercised stock options? If so, it’s important to know key dates and values for those actions.

Without knowing what you own and what has already occurred, it’s difficult to evaluate and create a strategic plan to manage your concentrated equity position.

Step 2 – What is the Cost Basis?

Cost basis is important because it impacts income taxes. Knowing the cost basis will help determine what type of tax will be paid and how much tax may be owed. From this, you can calculate how much you will receive net of income tax from the sale of your stock, or in other words, how much you have to spend.

Capital gain is what you have earned on the company stock over what you paid for it. When you sell your company stock, the gain (or loss) is subject to capital gains tax.

In its most simple format, cost basis is calculated as what you paid for the stock when you purchased it.

However it’s not always that easy. In fact, a more complicated cost basis scenario is that of incentive stock options. With incentive stock options, it’s possible your stock may have both a regular cost basis and an alternative minimum tax (AMT) cost basis, both of which should be tracked until liquidation of the stock. And both of which may have a material impact on income tax.

Other complicated cost basis scenarios may include net unrealized appreciation, which involves the tracking of cost basis for company stock purchased inside a 401(k) plan or cost basis for restricted stock with an 83(b) election.

Furthermore, for every lot of stock options or stock shares that are owned outright, it’s possible you will have a different cost basis.

Step 3 – What Key Dates Do You Need to Know?

It’s very common for company stock ownership to have key dates that should be tracked.

For calculating capital gains tax on the sale of shares that are owned outright, one year is an important date in that shares may be eligible for preferential long-term capital gains treatment.

Other important dates include vesting dates, expiration dates, and dates associated with a qualified disposition.

A vesting schedule is used to determine when you can take action on restricted stock and/or stock option plans. Prior to shares vesting there is a substantial risk of forfeiture. What you own is likely a future promise should you meet certain criteria. Once vested, that promise is fulfilled and you gain the ability to control your shares.

Vesting schedules may also drive taxability (depending on the type of company stock you have). For example, restricted stock is often taxable when it vests.

For stock options, a vesting schedule is important because it dictates when you can exercise your options. Prior to this date, you have no ability to exercise. Post vest, you can exercise as you wish.

The expiration date is on the other end of the spectrum as compared to vesting. The expiration date of stock options is the date on which the option goes away should you not exercise.

If your stock options are underwater and the expiration date passes, the stock options will disappear and be worthless.

If your stock options are in the money and you approach an expiration date, it likely makes sense to exercise the shares regardless of impending taxability. Otherwise, any in the money value will evaporate upon expiration.

A third set of dates that should be considered are those associated with a qualified disposition. For shares owned via an employee stock purchase plan and/or incentive stock options, meeting the standard required of a qualified disposition is likely advantageous from a tax standpoint.

However, seeking a tax advantage requires assuming risk – the risk of holding company stock for a certain period of time. During this time, the shareholder (you) is subject to market risk, or the risk of the stock price going down.

What you seek to save in tax may be lost due to a declining stock price.

Step 4 – How Much of Your Overall Investment Portfolio Is Invested in One Company?

Concentration risk is the risk of owning too much of one thing. In our discussion, this means too much of one company stock. This risk may result from a variety of situations including the focus of this article, company stock that is accumulated through employment.

Concentration risk isn’t all bad. In fact, concentration risk presents both opportunity and risk. When the company is doing well and valuations are going up, you will likely benefit from concentration risk.

However, during periods of poor company performance or enhanced volatility, concentration risk can lead to unpredictability and potential financial insecurity.

Furthermore, one could argue concentration risk is enhanced for someone who owns too much company stock AND is employed by said company. In a bad scenario, the stock price may drop precipitously as you get laid off and lose your income and benefits.

For these reasons, it’s important to understand how much concentration risk you have and how much concentration risk you are comfortable assuming. One rule of thumb in the industry suggests someone may want to own between 10-15% of any one company in a portfolio.

A more complete analysis of concentration risk and individual suitability would likely consider your overall net worth, your liquidity needs, your life stage, and your future plans.

Step 5 – Plan for Concentration Risk and Financial Planning

Managing your overall investment portfolio and financial plan requires a thorough analysis of your company stock and stock options. By combining the details of your plan with the goals of your financial plan, it’s possible to create an arrangement that strives to maximize value.

While there is no assurance that a diversified portfolio will produce better returns than an undiversified portfolio, and it does not assure against market loss, a diversified portfolio may reduce a portfolio’s volatility and potential loss.  None of the information in this document should be considered as tax advice.  You should consult your tax advisor for information concerning your individual situation.

 

Comparing the Solo(k) and SEP-IRA for the Self-Employed

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For those who are self-employed, the question of how to save for retirement is a frequent one. Fortunately, the answer may not be that that difficult at all.  In fact, being self employed may mean that you have more retirement planning opportunities than you otherwise would have access too.

This is because as the employee/owner of your company, you can choose a retirement plan that fits your specific wants and needs.

Looking to keep things simple and straightforward? There is an answer for that. Looking to max fund a plan as quickly as possible? There is an option for that, too.

Ultimately, the final decision on which retirement plan you choose will reflect your wants, needs, income, structure, growth, employees, and so on.

So while the options are plenty, the final decision takes a bit more consideration.

From Employee to Employer

As an employee, your retirement savings options may be limited by how much you (and your family) make and whether or not your company offers a retirement plan. The combination of these rules impacts how much you can contribute to a plan.

One of the more common retirement saving vehicles for employees is the 401(k) plan. On the surface, the 401(k) plan is straightforward (at least for an employee).

Upon becoming eligible for the plan, an employee can defer from payroll into a plan. It’s simple – once it has been decided how much to contribute to the plan, the employee completes the paperwork, and the company processes the deferral.

Furthermore, some employers encourage you to participate in the plan by offering company match and/or a profit share contribution.

While the rules for a 401(k) can be considerably more complicated past the surface, the concept of a enrolling in a plan and having your contributions deducted from your payroll is common to many.

Retirement Plans for the Self-Employed

As you transition from employee to self-employed business owner, the retirement savings world changes. You go from being offered a retirement plan by your employer, to choosing which retirement plan suits you best.

At your immediate disposal are several options, two of which we will highlight here.

  • A SEP IRA
  • A 401(k) and/or profit sharing plan (solo(k))

Which one you choose depends on a number of considerations. How much you make. Your business structure (Schedule C or S-Corp). How many employees you have. Expected changes in the business. Annual funding goals. And how easy or hard you want the plan’s administration to be.

For the purposes of today’s discussion, we will focus on retirement plans for self-employed individuals with zero employees. Basically, a one-person company. You.

Earned Income vs. Wages

The maximum annual retirement contribution you as a self-employed person can make is subject to how much income you earn and what type of retirement vehicle you are funding. Furthermore, these income calculations are dependent on your company structure. Commonly, structure is divided into two camps.

  1. Income that is reported on Schedule C of a personal tax return
  2. Income from an S-Corp in the form of wages and a dividend

While these individual structures have benefits and drawbacks, the scope of why one is right or wrong is a discussion for a different day.

What is important today is to know that with both a Schedule C and an S-Corp, the business owner has the option of implementing a SEP-IRA or a Solo(k) for retirement savings.

Maximum SEP-IRA Contribution

A SEP-IRA is simple and straightforward, and the amount a business owner can contribute is high. In fact, a business owner can contribute up to 25% of his/her earned income up to an annual maximum contribution of $56,000 (in 2019).

Additionally, a SEP-IRA may be attractive thanks to low administration expenses and ease of operation. However, what is gained in ease of administration is lost in contribution flexibility.

Using a hypothetical example, we can illustrate the maximum funding for a SEP-IRA based on various income levels and company structures. Let’s explore:

The chart below illustrates the maximum allowable contribution (25%) to a SEP-IRA assuming the various wages. The simplifying assumption in our hypothetical example is that $100,000 is the net Schedule C income and $100,000 is the S-Corp W2 wage.

$100,000 $150,000 $200,000
Schedule C $18,587 $27,950 $37,816
S-Corp $25,000 $37,500 $50,000

Without detailing the specific calculations, you can see that the S-Corp allows for higher annual retirement plan contributions compared to a Schedule C, assuming the same wage.

Solo(k) and Profit Sharing Plan

A second option for the self-employed business owner is a Solo(k) and profit sharing plan.

A Solo(k) has additional features compared to its SEP-IRA counterpart, including higher contribution rates at lower income levels and the option for a ROTH 401(k) component. For this tradeoff in options, a Solo(k) and profit sharing plan have increased administration costs and increased complexity.

Continuing our example from above:

Schedule C – Solo(k) and Profit Sharing Plan (using 2019 figures)

$100,000 $150,000 $200,000
401(k) Deferral $19,000 $19,000 $19,000
Catch up (age 50+) $6,000 $6,000 $6,000
Profit Share $18,587 $27,950 $37,816
Total $43,587 $52,950 $62,000

 

S-Corp – Solo(k) and Profit Sharing Plan (using 2019 figures)

$100,000 $150,000 $200,000
401(k) Deferral $19,000 $19,000 $19,000
Catch up (age 50+) $6,000 $6,000 $6,000
Profit Share $25,000 $37,500 $50,000
Total $50,000 $62,000 $62,000

 

The rules regarding contributions to a Solo(k) are different than the SEP-IRA. Specifically, a business owner who implements a Solo(k) can defer from his/her salary up to $19,000 (in 2019) of earned income per year (plus an additional $6,000 if 50 years of age or older).

Simply stated – this deferral feature of the Solo(k) allows for a business owner to get money into the plan quicker than would be allowable via a SEP-IRA.

In addition to the $19,000 deferral, the business owner can add a profit-sharing component that allows him/her to contribute an additional 25% of earned income (for a total of $56,000, or $62,000 if 50 years of age or older).

Planning the SEP and Solo(k)

Comparing the SEP IRA to the Solo(k), we have illustrated that at lower wage levels, the Solo(k)/PSP substantially increases allowable annual contributions to a retirement plan.

A recap of the figures

SEP – Schedule C SEP – S-Corp Solo(k) – Schedule C Solo(k) – S-Corp
$100,000 $18,587 $25,000 $43,587 $50,000
$150,000 $27,950 $37,500 $52,950 $62,000
$200,000 $37,816 $50,000 $62,000 $62,000

 

As you can see, at “lower” income levels, the spread between the maximum allowable contributions is significant.

Specifically, if we compare the SEP Schedule C to the Solo(k) Schedule C for someone making $100,000, we can see an increased contribution of $25,000.

As the income levels increase from $100,000 to $150,000 and $200,000, the advantage of the Solo(k) becomes less and less. At some point, the advantage may become so small that the cost of administration and the complexity of the 401(k) plan may not be worth the trouble.

Other Factors to Consider

Just like most topics in financial planning, a comparison of a SEP-IRA vs. a Solo(k) is difficult. In fact, a full analysis will require addressing additional questions like the following:

  • How much am I looking to save?
  • Can I afford to save?
  • Should I consider a ROTH option?
  • What is fair and reasonable compensation for an S-Corp business owner?
  • What other taxes should I consider?
  • For how many years will I be saving?

Ultimately, it is important to have an adequate understanding of the available options and how much you can save. Because the difference between saving $18,000 per year or $42,000 per year over the course of 10, 20, or 30 years can be big.

 

The above figures are hypothetical and for illustrative purposes only and do not attempt to predict actual results of any particular investment.

401(k): Reduces current federal taxable income; Contributions grow tax deferred until withdrawn; Withdrawals taxed as ordinary income in the year received. Tax penalties and penalties for early withdrawal may apply if funds are withdrawn prior to age 59 1/2.

An individual retirement account (IRA) allows individuals to direct pretax income, up to specific annual limits, toward investments that can grow tax-deferred (no capital gains or dividend income is taxed). Individual taxpayers are allowed to contribute 100% of compensation up to a specified maximum dollar amount to their Traditional IRA. Contributions to the Traditional IRA may be tax-deductible depending on the taxpayer’s income, tax-filing status and other factors. Taxes must be paid upon withdrawal of any deducted contributions plus earnings and on the earnings from your non-deducted contributions. Prior to age 59½, distributions may be taken for certain reasons without incurring a 10 percent penalty on earnings. None of the information in this document should be considered tax or legal advice. Please consult with your legal or tax advisor for more information concerning your individual situation.

Contributions to a Roth IRA are not tax deductible and there is no mandatory distribution age. All earnings and principal are tax free if rules and regulations are followed. Eligibility for a Roth account depends on income. Principal contributions can be withdrawn any time without penalty (subject to some minimal conditions).

What Is Net Unrealized Appreciation?

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If you own company stock inside your 401(k) plan, you may want to know about net unrealized appreciation. Net unrealized appreciation, or NUA, is a financial planning technique that may allow you to obtain preferential tax treatment on a portion of your 401(k) assets.

Most people with a 401(k) plan understand that they will pay ordinary income rates on money withdrawn (assuming they contributed pre-tax, non-Roth 401(k) money). For the most part, this assumption is true.

Using net unrealized appreciation, however, you may be able to transfer a portion of your 401(k) assets to receive long-term capital gains treatment. Long-term capital gains tax rates tend to run lower than ordinary income tax rates; they can be as low as 0% or as high as 20%. They’re often somewhere in the middle, at 15%.

The more the value of your 401(k) is tied up in company stock, and the greater the spread between the cost basis (what the shares of the stock cost when they were purchased in your 401(k) plan), the more likely it is that using NUA will be a valuable planning technique.

A Simple Net Unrealized Appreciation Example

Let’s assume that you are a 65-year-old retiree with $1,500,000 in an employer-sponsored 401(k) plan.  Let’s further assume $500,000 of the total account balance is invested in company stock, and that stock has a cost basis (what you paid for it) of $75,000.

In this scenario, you have several options to consider. A few common options include keeping the 401(k) plan assets where they are, rolling the assets to an IRA, taking a distribution of some plan assets, or taking a distribution of all the plan assets.

You will want to check your plan document to see exactly what rules pertain to your plan and what your options may be.

To simplify our net unrealized appreciation example, let’s assume that you only have two options for your 401(k) plan:

  1. Keep the money in the 401(k) and/or roll the account over to a tax-deferred IRA
  2. Use net unrealized appreciation

Option 1: Keep Funds in the Plan or Roll the 401(k) into an IRA (and Do Not Use NUA)

If you choose option 1 and do not use net unrealized appreciation, you will keep all your assets inside a 401(k) or an IRA. Assuming all the assets are pre-tax assets, all future account distributions will be taxed as ordinary income. In our example, this means all 1,500,000, as well as future growth, will be subject to ordinary income when distributed.

Option 2: Use Net Unrealized Appreciation

If you have company stock inside your 401(k) plan, you may want to consider net unrealized appreciation so you can take advantage of long-term capital gains rates.

Here is a general idea of how it works:

  1. You elect to take a distribution of company stock inside your 401(k) plan “in-kind.” This means you will transfer company stock inside your 401(k) to a non-IRA investment account.  When this transaction occurs, you are creating a taxable event to report on your tax return for that calendar year. The amount that is taxable is the cost basis of the company stock.
  2. If you have a capital gain in the company stock (the difference between the cost basis and the fair market value), it is immediately eligible for preferential long-term capital gains treatment.
  3. If you are distributing the entire 401(k) account balance during this same process, the remaining balance can likely be rolled over into an IRA in a non-taxable event. If you do not roll this over and take it as a distribution, you may be subject to ordinary income on the distribution.

The Potential Value of Net Unrealized Appreciation ‒ A Tax Comparison

A simple tax calculation comparing tax implications for a scenario with net unrealized appreciation and another scenario without allows us to illustrate the potential value of this technique.

Let’s assume that the current fair market value of your company stock is $500,000 and the cost basis of the stock is $75,000. In order to run a calculation to show the two different outcomes, we need to make some simple assumptions as they pertain to tax.

We’ll assume the following:

  • Ordinary Income Tax Rates: 33%
  • Long-Term Capital Gains Tax Rate: 15%

Finally, assume that in each scenario, the full $500,000 is distributed from the 401(k) and converted to cash as quickly as possible.

Using this hypothetical, it is easy for us to illustrate the outcome, as detailed in the chart below:

Fair Market Value Taxed as Ordinary Income Taxed as Capital Gains Ordinary Income tax (33%) Capital Gains Tax (15%) Total Tax
No NUA $500,000 $500,000 $0 $165,000 $0 $165,000
NUA $500,000 $75,000 $425,000 $24,750 $63,750 $88,500

In the “No NUA” scenario, the entire $500,000 is distributed and taxed at 33%. The tax due is $165,000.

In the “NUA” scenario, assuming that the stock is sold immediately after it is distributed and taxed at long-term capital gains rates, the tax liability is $88,500.

In this simple example, net unrealized appreciation saves over $80,000 in taxes.

When Net Unrealized Appreciation May Make Sense

It is easy to make net unrealized appreciation look attractive using a hypothetical illustration as detailed above, but it may not make sense for every single situation. Here are some specific times when you should consider this strategy:

  • If you have highly appreciated stock in your 401(k) plan

If you have company stock that has gone up substantially in value, net unrealized appreciation may be something to consider. The larger the spread between the cost basis and the current market value, the stronger the argument for net unrealized appreciation. This is because the larger the capital gain, the larger the opportunity to pay capital gains tax in lieu of ordinary income tax. Paying 15% in lieu of paying 33% may lead to major tax savings.

  • Large Spread in Tax Brackets

Tax brackets change based on levels of income for both ordinary income tax and capital gains tax. The larger the spread between the two, the greater the opportunity will be to utilize preferential long-term capital gains treatment.

  • When You Are Seeking to Lower Your Required Minimum Distributions

Diversification* is a common term that is used when it comes to investing. In short, it simply means don’t have all your eggs in one basket.

As diversification pertains to retirement income planning, it may also mean tax diversification, or having different types of assets in retirement. This means taxable assets, tax-deferred assets, and tax-free assets. Net unrealized appreciation can be a strategy that efficiently transitions tax-deferred assets and makes them taxable. Since the portion of your assets that is subject to NUA are no longer in an IRA or 401(k), the account value will not be included in the RMD calculation. This transaction has the net effect of lowering RMDs in retirement.

Should You Consider Leveraging Net Unrealized Appreciation?

If you think net unrealized appreciation is something you would like to consider, start by checking your employer 401(k) plan document to see what rules may pertain to your plan.

It might also make sense to speak with an expert who can help you sort through the details so that you can determine how big the spread between the cost basis and fair market value is and how NUA fits into your overall financial plan.

Implemented appropriately, net unrealized appreciation may lower your overall net tax liability, therefore leaving you with more cash in your pocket.

*Diversification does not guarantee a profit or protect against a loss.

Tax services are not offered through, or supervised by Lincoln Investment, or Capital Analysts.

None of the information in this document should be considered as tax advice.  You should consult your tax advisor for information concerning your individual situation.

An individual retirement account (IRA) allows individuals to direct pretax income, up to specific annual limits, toward investments that can grow tax-deferred (no capital gains or dividend income is taxed). Individual taxpayers are allowed to contribute 100% of compensation up to a specified maximum dollar amount to their Traditional IRA. Contributions to the Traditional IRA may be tax-deductible depending on the taxpayer’s income, tax-filing status and other factors. Taxes must be paid upon withdrawal of any deducted contributions plus earnings and on the earnings from your non-deducted contributions. Prior to age 59½, distributions may be taken for certain reasons without incurring a 10 percent penalty on earnings.

Prior to rolling over assets from an employer-sponsored retirement plan into an IRA, it’s important that you understand your options and do a full comparison on the differences in the guarantees and protections offered by each respective type of account as well as the differences in liquidity/loans, types of investments, fees and any potential penalties.

How to Strategically Liquidate Company Stock and Employee Stock Options

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Many financial planners will suggest that you allocate no more than 10-15% of your investable net worth into a single stock position. That range can allow you to benefit from the potential upside of a growing, successful company, without leaving your assets too vulnerable to a less-desirable outcome if the company underperforms.

If you want to follow that guideline and you receive equity compensation, that means understanding how to strategically liquidate company stock whenever you could potentially exceed that suggested threshold.

That’s a task that can get complicated, and fast. To help you manage it, here’s what you need to know.

Liquidating Company Stock Requires Consideration of Several Variables

The suggested guideline for how much exposure to a particular stock that’s safe to maintain is just that: a guideline. The 10-15% range is not a hard and fast rule, so the first thing to understand is that you don’t have to maintain this all the time with no exceptions.

There may be times when you intentionally hold your shares in hopes that the stock price increases. Other times, holding period requirements, unvested shares, stock price fluctuations, blackout or lockup periods, and other factors may prevent you from having complete control over what percentage of your net worth is exposed to those shares at any given moment.

The second major consideration when thinking about how to strategically liquidate company stock is potential tax impacts. The tax rules that apply will vary depending on whether you have an employee stock purchase plan, non-qualified stock options, incentive stock options, or restricted stock.

For example, you may want to consider questions like:

  • Should I recognize ordinary income now, or defer it until later?
  • Do I have stock with a basis that is equal to the market value of the stock that I can liquidate with little or no tax consequences?
  • Do I have stock at a loss?
  • Should I exercise and hold options to take advantage of long-term capital gain rates in the future?
  • What is the AMT impact if I exercise and hold my incentive stock options?

There is no single“right” answer to these questions. But it is possible to develop a strategic way to liquidate company stock by considering what type of equity comp you have and what tax considerations apply to your situation based on what you have — and your overall investment goals and objectives.

The Tax Impact of Liquidating Shares of Company Stock You Own Outright

If you don’t receive equity compensation, you can still own company stock by purchasing it on the open market through a brokerage account or other investment account. When you purchase any stock, from your company or otherwise, the price you pay for shares is known as the cost basis. Generally speaking, the tax implications when you sell your shares will be based on the cost basis and the fair market value when you sell.

Before selling out of any positions, you’ll want to consider whether the action will result in a short-term capital gain (or loss) or a long-term capital gain (or loss).

Short-term capital gains (and losses) will be recognized if you sell the shares within one year of purchase, and will be taxed at ordinary income tax rates. You’ll have a long-term capital gain (or loss) if you sell the shares one or more years after the date of purchase.

Long-term capital gains are taxed at different rates than ordinary income. If you have a long-term capital gain or loss, the tax rate can be as low as 0% or as high as 20% (for 2021), but you’ll commonly see these at 15%.

Tax Considerations for Liquidating Company Stock from an ESPP

An employee stock purchase plan (ESPP) is a benefit that allows employees to purchase shares of company stock through convenient payroll deductions. If the plan is a qualified ESPP, you may be able to purchase shares at a discount of up to 15%.

Some plans also allow participants to take advantage of a lookback provision as well. This benefit allows you to purchase shares at the offering date price or the purchase date price, whichever is lowest and therefore best for you as the buyer.

There’s no reportable tax event when a qualified ESPP purchases shares on your behalf. However, you do create a taxable event once you sell these shares. The type of tax you need to report and how much you owe depends on a few key factors, including:

  • The timeline between the offering date, the purchase date, and the sale date of your shares
  • The discount received
  • The purchase price and the sale price of the stock.

You may need to claim ordinary income and capital gains (or losses) when you sell your shares. Because so much depends on each individual situation, you may be best served by speaking with a financial advisor and CPA with experience in helping clients managing equity compensation so you know precisely how much you may owe.

How You’re Taxed When You Sell Restricted Stock Units (RSUs)

If you receive restricted stock units (RSUs) as part of your equity compensation, nothing is taxable until your shares vest. Once vested, the total value of the RSUs is subject to being taxed at your ordinary income rate.

Many employers automatically withhold 22% of the value of RSUs once they vest to help employees manage this tax burden. This withholding will cover some or all of the taxes you owe from your vested RSUs, although you may owe more depending on your income tax bracket.

The remaining value of the RSUs will typically be given to you as shares of stock that are deposited into an investment account. The shares often have a cost basis that is equal to the share price when the RSUs vested.

Once RSUs vest, the shares you receive look and act like shares that were purchased outright. If the shares are sold within a year, short-term capital gain/loss tax rules apply. If you hold the shares for longer than a year, the shares will qualify for long-term capital gains/losses when you eventually sell.

Understanding Taxes on Non-Qualified Stock Options

Restricted stock units limit your control over when you can recognize income from them and therefore when you owe taxes, because they’re subject to a vesting schedule. Non-qualified stock options (NQSOs), on the other hand, give you more control over triggering a taxable event.

NQSOs are issued with an exercise price, or the cost of buying the shares. If the current share price of the stock exceeds the exercise price, the stock option is “in-the-money.” If the current share price of the stock is less than the exercise price, it may not make sense to exercise the option and you don’t have to do so.

Your NQSOs become taxable when you exercise them. The spread between the exercise price and the fair market value at exercise is the amount subject to ordinary income and payroll taxes.

Using an example to illustrate, assume your company grants you 1,000 NQSOs with an exercise price of $5. Three years later, the market price of the stock is $50. If you exercised your options at that point, you’d need to claim the following as ordinary income on your tax return:

Ordinary Income = Number of Shares Exercised x (Fair Market Value at Exercise – Exercise Price)

1,000 x ($50 – $5)

=$45,000

Non-qualified stock options can be attractive because there is some control regarding what calendar year the income is recognized. Should you be a high-income tax year, it may make sense to not exercise because it could push your taxable income even higher. Exercising in a lower-income year can make more sense if it saves you on taxes.

If you hold your shares after you exercise your NQSOs, the cost basis of the stock is commonly equal to the fair market value at exercise. Like RSUs that are retained post-vesting, stock you own after exercising looks like shares that were purchased outright.

The Taxes You May Owe on Incentive Stock Options (ISO)

Incentive stock options are often the most challenging in terms of income recognition and subsequent taxation. The taxes you owe can be subject to the timelines between when ISOs are granted, exercised, and sold. The type of tax you’ll owe can vary, too.

With ISOs, you may need to pay ordinary income tax, capital gains tax, the alternative minimum tax (AMT), and potentially other types of taxes as well.

While incentive stock options can present added complications when compared to other types of equity compensation, they also provide some tax opportunities. If you exercise your ISOs according to certain rules, you could secure a lower tax rate on what you owe.

To have your liquidation of shares received from ISOs qualify for long-term capital gains tax rates (rather than ordinary income tax rates), you will need to need to meet the following criteria:

  • The final sale of stock occurs at least two years past the grant date, AND
  • At least one year past the exercise date of the option.

Doing so provides you with a qualifying disposition. But if you do exercise and hold shares from your ISOs for one year to achieve this, you may then need to pay the alternative minimum tax (AMT).

You can trigger owing AMT in the year you exercise your shares. The amount you owe is commonly based on the spread between the exercise price of the option and the fair market value when you exercise.

For more information about the alternative minimum tax, you may want to dive deeper into the topic here .

What Does This All Mean?

If you want to strategically liquidate company stock you received through some kind of equity compensation, you need to consider exactly what type of equity you have, where the shares came from, and what the tax implications for your actions may be.

A good strategy to unwind concentrated equity will likely consider both short- and long-term tax implications, current financial conditions, future financial expectations, all the available holding positions, and a shareholder’s overall investment goals and objectives.

*Asset allocation or diversification do not guarantee a profit or protect against loss.

None of the information in this document should be considered as tax advice.  You should consult your tax advisor for information concerning your individual situation.  Tax services are not offered through, or supervised by Lincoln Investment, or Capital Analysts

The above hypothetical examples are for illustrative purposes only and do not attempt to predict actual results of any particular investment.

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