Employer Stock Planning in the year of retirement for NQSOs or ISOs
First off, congratulations! You have sacrificed, saved, and worked hard to be in the position you are today. But before you retire and enter an exciting new chapter of life, let’s look at some planning items to consider when it comes to selling your employer stock options in the year of retirement.
If you work for a publicly traded company like several in the Minneapolis area like Target, Best Buy, United Health group, Medtronic, Boston Scientific, General Mills, you may find yourself having accumulated substantial amounts of several types of employer stock over the years – ESPPs, RSUs, ISOs, NQSOs. This article doesn’t get into the details of each – but if you’d like to dive into those details please see In Depth Understanding of Employer Stock Compensation. Instead we will run through some planning items to consider in the year of retirement related specifically to Nonqualified Stock Options and Incentive stock Options.
In many cases when you leave the company, whether it is because you’re retiring or taking another job opportunity, you generally have 90 days from the date you sever your employment to exercise your vested options. It’s important that you review your company’s plan document to understand the exact timeline for when you have to exercise. For purposes of these examples will assume a 90-day timeframe when separating from your job.
Exercise NQSOs in the following tax year when income drops
If you were planning to retire late in the tax year like October, consider pushing your retirement date into early the following year to push the NQSOs income into another tax year when wages are reduced significantly.
There are a couple benefits this provides the retiree by doing this. First, the ordinary income related to NQSOs when exercising will now be spread over two tax years. It allows you to fill up your lower tax brackets in the year of retirement when you income from wages drops and avoid being exposed to higher marginal rates than you would otherwise be exposed to if you did it all in one tax year. To understand the potential tax savings that could come related to this strategy - let’s look at an example.
Assume a married filing joint couple is at the top of the 24% tax bracket – in 2020 that is taxable income of $326,600. They also have $150,000 of Nonqualified Stock Options to exercise at retirement. They are considering delaying retirement into January of the following year in an effort to exercise and sell the NQSOs in the next tax year when earned income drops significantly. They are unsure if the tax benefits of delaying retirement to execute this strategy are worth it or if they should just retire in the fall and exercising the $150,000 of options all in the same tax year.
If the couple is at the top of the 24% tax bracket already, any additional income from exercising the options will now be taxed at higher marginal rates. In this example if they decided to exercise the options in the year where they virtually had a full year of earned income that additional $150,000 worth of options would create a Federal tax of $49,857. They would fill up the entire next tax bracket of 32% ($88,100 of the options taxed at 32%) and go into the 35% for the remainder of the income (remaining $61,900 of options taxed at 35%).
If instead, they waited until January of the following year where income from wages is more or less zero (to keep the example simple) that $150,000 would create just $24,580 in Federal taxes because much of the income is being taxed at lower rates. If you only had the $150,000 as income in that tax year you would fill up the 10%, 12%, and most of the 22% tax bracket. That is a 50% or $24,580 reduction in tax related to your NQSOs by delaying retirement a couple months!
The other added benefit of retiring early into the next tax year, is that it can also provide you the opportunity to max out your 401(k) again to further reduce the tax impact. Note, make sure to adjust the allocation first thing Jan 1st if you tend to hit the max out evenly throughout year to ensure you hit max before ending employment.
As with implementing any tax strategy, you should always weigh the benefits of reduced taxes with the potential downsides of risk of delaying exercising. Look at how this potentially affects your financial plan in either scenario.
If the stock is historically volatile and or the company has struggled in the past or potentially faces financial headwinds in the near term; weigh the benefits of delaying an exercise to achieve lower taxes versus realizing the value now.
On the flip side, if the company is a well-capitalized stable company and historically doesn’t have large swings in share price, the risk of the stock price going down may be less of a concern and worth taking to achieve more favorable tax results.
Exercise/hold ISOs early in the tax year; then one year later use the proceeds for spending in the 1st year of retirement
Exercise ISOs early in the tax tax year with the goal of achieving favorable long-term capital gains through a qualifying disposition. Then use the proceeds to live off of in your first year of retirement. This accomplishes two things 1.) more favorable tax rates and 2.) reduces risk in the portfolio upfront.
But before we go any further, lets quickly run through what a qualifying disposition is and a disqualifying disposition to understand the differences in how they are taxed.
In order for ISOs to be taxed at favorable long-term capital gains rates versus ordinary income rates the sale must be classified as a qualifying disposition. In order the sale to be a qualified sale the employee will need to meet the following two holding periods:
The stock sale must occur at least 2 years from the options grant date
The stock sale must occur at least 1 year after the date you exercised the stock.
I either one of these conditions are not met, the sale would be considered disqualifying and the entire bargain element (difference between the current stock price and exercise price) would be taxed as ordinary income rates.
Below illustrates the tax difference between a qualifying and disqualifying dispositions:
Assumptions - taxpayer’s marginal rate is 24% with long-term capital gains rate at 15%.
Let’s walkthrough a scenario to illustrate how you can execute this. Assume its January 1st and you plan on working through the calendar year before retiring. By exercising your ISOs today on January 1st, you start the clock for the holding period of at least 1 year from the date you exercise before selling. Lets also assume you are well past the 2-year date of grant and most retiring scenarios this will likely be the case as you were likely awarded these options earlier on in their career.
If you sell the exercised ISOs after the one year mark, essentially right after you retire, you will have achieved long-term capital gains rates, reduced risk in the portfolio (going forward), and now you have the proceeds from sale available to live off of in the first year of retirement. So, if we look back at the above example and realize $150,000 in value you will have saved $12,690 in taxes! Looking at it another way, you will have $12,690 more available to spend!
While the allure of paying long-term capital gains rates versus ordinary income rates can be hard to pass up, it is not always that straightforward. Some things to consider when employing a strategy to achieve these favorable tax rates is risk and AMT (Alternative Minimum Tax).
It is important for everyone to consider the amount of risk they can afford to take when it comes to holding employer stock. If you have a considerable amount of employer stock that makes up most of your investable wealth, weigh the benefits of continuing to hold the stock to achieve long-term capital gains rate. A lot can happen to a stock’s price in one year, and it’s not always good. If the stock takes a dive while you are trying to achieve long-term gains rates, that decline could cost you much more in lost value versus the tax savings.
Alternative minimum taxes are also important to consider when it comes to exercising ISOs. If an employee exercises options and holds the stock, the bargain element will be included for AMT tax purposes in the tax year of exercising. This can come as a huge surprise come tax time if not properly planned for and can cost employees thousands of dollars in extra taxes if not properly executed. There are also other planning considerations to keep in mind if the stock declines in value after you’ve exercised and while you are holding it. In some instances, it may make sense to purposefully cause a disqualifying position to avoid the AMT.
There are many factors to consider when employing these strategies and everyone’s situation is different and specific to their financial plan. It is advised you work closely with your advisor and tax professional when trying to implement these.
If you have questions about your employer stock, utilizing effective sales strategies to reduce risk and taxes, or how this all relates to your retirement plan, schedule a phone call to discuss with a Phillip James advisor.
All the information contained herein is for illustrative purposes and should not be relied upon for tax, investment, or legal advice. You should consult with your fiduciary financial advisor planner to decide what is best for you based on your specific situation. It also helps if your advisor is a tax preparer to understand the tax impact of implementing specific strategies.