Although things like employee stock options or restricted stock may sound similar, the rules around each get complicated — and fast.
Everything from when you exercise, how you exercise, and what type of vehicle you own impacts the after-tax amount you receive (and when you receive it). Not only that, but each of these factors may also impact how much Social Security income you get, how your Social Security is taxed, and when the best time to collect your benefits may be.
This is a big reason why sound retirement planning that takes all your assets and options into account is critical.
Social Security Analysis Is Complicated Enough — and Options Only Make It More Complex
Part of this retirement planning includes Social Security, as nearly every retirement plan is impacted by the fact that you can likely claim some level of benefits. And if you listen to the informed masses, Social Security isn’t running out of money any time soon.
To properly plan around this income source, you’ll want to do a Social Security analysis. This can help you make decisions around when to file (whether early, at full retirement age, or late to get the maximum benefit).
An analysis can also help you determine:
- How much Social Security Income you will receive
- How other earned income impacts your Social Security benefits
- How your Social Security income will be taxed may have material impact on which option is best.
Strategizing for the best Social Security option is, by itself, a difficult task. It can get even more complicated when you also look at other retirement considerations such as other income sources, expense needs, IRA assets, non IRA assets — and of course, stock options and restricted stock.
How (and Where) to Start Your Analysis
Still, despite the complexity, you need to begin somewhere. One good place to start your analysis is by breaking Social Security income into three distinct segments.
Specifically, these segments are:
- Eligible to receive Social Security, but Social Security is reduced if you have earned income.
- Eligible to receive Social Security, and Social Security is not reduced with earned income.
- Eligible to receive Social Security, Social Security not reduced with earned income, and your Social Security benefit has maxed out.
Generally speaking, option 1 addresses ages 62 to your full retirement age (FRA). Your FRA is subject to the year you were born, but is likely between 66-67 years old.
If You File Early for Social Security Benefits
During this time frame, you can begin collecting Social Security. But if you file for benefits prior to your full retirement age, you’ll receive a reduced amount of your FRA benefit.
Said another way, when you file early and collect at 62 (which you can if you have qualified for Social Security), you actually receive less than your calculated benefit.
Your already reduced benefit may be further reduced if you collect Social Security prior to FRA and continue to have earned income. Depending on how much you make outside of Social Security income, your benefit could be as little as $17,040 (in 2018) if you file early.
If you find yourself collecting Social Security prior to your FRA and you plan to work, you should check to determine how much you can make prior to receiving a reduced benefit. The specific rules for how much you can make and how your Social Security benefit is reduced can be complicated, and they change once again in the year you reach FRA.
In your FRA year, not only is the earnings test higher (meaning you can make more before suffering a reduced benefit), but only the amount earned before the date you reach FRA counts.
If You File at Full Retirement Age (or Beyond)
Option 2 is your FRA. At your full retirement age, you’re entitled to receive 100% of your calculated Social Security benefit (this amount is known as your primary insurance amount, or PIA).
You’re no longer subject to the earnings test, either. The IRS allows you to make as much as you can while collecting Social Security without being penalized via a reduced benefit.
For many reasons, collecting Social Security at FRA can be seen as a good thing. You can make as much as you want and still collect, benefiting from a “dual income.” You’ve also reached the age when you are entitled to 100% of your benefit.
However, continuing to delay beyond your FRA may make sense for many reasons. Between age 66 and age 70, the amount you can receive from Social Security grows at 8% per year.
This means a deferral of 4 years on your Social Security income can increase your monthly income amount by over 30%.
Option 3 is the option which attempts to maximize your Social Security income. At age 70, your Social Security benefit maxes out and there is likely no longer a need to wait.
Where Employee Stock Options Come into Play
Planning your Social Security income strategy is an important consideration for any retirement plan. A good Social Security strategy will consider income, expense, assets, tax, and longevity needs.
A retiree with no assets and no income may be forced to take Social Security early, as a way to pay the bills. Alternatively, a retiree with pensions, IRAs, non-qualified assets, employee stock options, and income earning potential may look at Social Security from a considerably different perspective.
If you’re dealing with non-qualified and restricted stock, that means you too should look at Social Security from a different perspective.
Specifically, you most likely will want to wait to take Social Security until age 70. You can supplement lower-income years with the exercise and sale of your employer stock and stock options.
Using Stock Options to Cover “Low-Income” Years in Retirement
A low income year, as I am using it for this illustration, is often the result of a gap year (or years) between retirement and age 70. During this gap, your taxable income may be considerably lower than it had been previously while you were working (you are no longer being paid).
To illustrate these low income years, I have used actual tax planning software (specfically 2017 Lacerte Tax planner and 2018 tax code) to simulate the tax return of a 67 year old married couple. The results you see below are actual tax figures as calculated by the software.
For the simulation, I have assumed zero wage income, zero pension income, zero Social Security income, and zero income from other investments, real estate, and so on. I further assumed this family is a standard deduction ($26,600)
(It goes without saying that a personalized tax projection should be completed to see where you fall.)
Low income “gap” years may also be great years to perform Roth conversions, explore the opportunity for net unrealized appreciation (NUA, or sell other low basis investments at potentially preferential long-term capital gains tax rate.
ROTH Conversion – A Roth conversion is the process of taking money from a traditional IRA and converting it to a Roth IRA. When you convert money into a Roth IRA, all pre-tax money is taxed as ordinary income. Future withdrawals, assuming they meet the requisite 5 year period, are tax free.
- If we convert $100,000, the total federal income tax due is $8,430 (based on the assumptions detailed above)
The value of a ROTH conversion is better illustrated by using the actual results of the tax planning software than it is using a simple ordinary income assumption of 33%. In our example, you can convert $100,000 into a ROTH IRA for “only” $8,430, or an 8.43% tax rate. A simple assumption ordinary income tax rate of 33% may overestimate your tax due by nearly $25,000.
Long-Term Capital Gains – Long-term capital gains have potentially preferential tax treatment (in relation to regular income tax) because their rates can range from 0% to 20%. A long-term asset is something that has been held for longer than 1 year.
- If we assume a $100,000 long-term capital gain, the total federal income tax due is $0
Long term capital gains rates are 0% if your taxable income is below $75,000. In a low-income year (or no-income year as illustrated), the taxable income is below that threshold, meaning all the capital gain is tax free. Again, significantly different than a simplified long-term capital gain tax assumption of 15% (or $15,000).
Non Qualified Stock Options and Restricted Stock –Non qualified stock options are taxed when they are exercised. Restricted stock is taxed when it vests. Both are subject to ordinary income tax as well as payroll tax (Medicare and Social Security tax). Continuing to use the assumptions from above and actual tax software, we calculate the following:
- If we assume $100,000 of income associated with non-qualified stock options or restricted stock, we can calculate a federal tax due of $8,430. Adding Social Security tax and Medicare tax, an additional $7,650 would be due, for a total of $16,080.
Net Unrealized Appreciation (NUA) – NUA allows you to transfer employer stock from a 401(k) plan into a non-IRA investment account. When you do, the cost basis of the employer stock is taxed as ordinary income, not subject to Medicare and Social Security tax. Once transferred, any gain over the cost basis is immediately eligible for long-term capital gains treatment. Again, the assumptions from above:
- If we assume $100,000 basis in company stock, the total federal income tax due is $8,430.
As you can see, these potentially low income years can be advantageous for someone who does not need to collect Social Security. Not only can low tax years be used to implement some or all of the strategies above (possibly for several years), they can be used to defer Social Security income until your benefit maxes out.
What If You Exercise After You Retire?
Further consideration should be paid to non-employee retirees who exercise restricted stock and non-qualified stock. For example, a retiree who exercises their awards after they retire.
As an employee, your employer often withholds the requisite income tax, Medicare tax, and Social Security tax when your shares vest (for restricted stock) or are exercised (for non-qualified stock options).
As a non-employee, that responsibility is yours. You will receive a 1099-MISC form at the end of the year that details your transactions. The transaction should be reported accordingly on a tax return, at which time you need to settle up on your tax bill.
Good planning would consider setting aside enough money from the sale of your stocks to pay the pending tax bill.
The Bottom Line on Social Security and Employer Stock
The rules for Social Security and the rules for all types of employer stock can be complicated. Often, a good first step is to get organized and understand exactly what you own.
Then, it makes sense to start setting goals. You have to know where you want to go before you can make a plan to get there.
Once you know what you own and know where you are trying to go, start thinking about your income needs, likely expenses, and opportunities or challenges you’ll face over the next several years.
You can then use this as a platform to overlay Social Security strategies, tax planning, and other exercise and income planning for your employer stock. Only after viewing your individual needs can you determine, what, if any, of the strategies above make sense.
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. The Lacerte Tax planner is not affiliated with the Lincoln Investment Companies.
This material is being provided for general information and educational purposes only and should not be construed as investment, tax, accounting, or legal advice, or used as the primary or final determinant of the best strategy on how and when to claim Social Security benefits. It is strongly recommended that each individual meet with a Social Security representative who can address his/her specific situation. A wealth of information, including interactive calculators, can be found at the Social Security Administration’s website: http://www.ssa.gov/pgm/retirement.htm.