Future tax rates on your mind? You're not the only one. Although less than three weeks remain before the current tax law ends at the close of 2012, the tax landscape beyond is still unclear. Unless a compromise is reached in Washington, tax rates will rise, though so far only the 0.9% Medicare tax increase and new 3.8% Medicare surtax seem to be beyond any possibility of modification.
In our most recent quarterly newsletter, we introduced two new FAQs discussing strategies with stock options and company stock holdings in light of potential tax increases after 2012. Both FAQs, also available in our section Year-End Planning, are reproduced in full below.
With the potential for tax-rate increases in 2013, I am thinking about exercising my nonqualified stock options to accelerate income into 2012. What issues do I need to think about?
Before you rush into exercising, you may want to do some calculations with potential future stock prices and tax rates. When you exercise earlier than necessary and pay taxes on your option spread, you lose some of the leverage that stock options offer. Experts feel the likelihood of higher tax rates ahead should not be the only reason for exercising at the end of 2012. The tools on myStockOptions.com, including the Quick-Take Option calculator, can help you consider various "what if" scenarios.
Here are some general situations where it makes sense to evaluate whether you should exercise options in 2012 rather than later:
- You were already planning to exercise options in next few years.
- The options are close to expiration.
- The options are deep in the money (i.e. there is a big spread between the market price and the exercise price).
- You need to diversify because your holdings are overly concentrated in company stock.
- You plan to change jobs soon. (Vested options almost always expire if they are not exercised soon after leaving the company.)
I am thinking about selling some company stock this year, before the new 3.8% Medicare surtax and the potential rise in capital gains tax rates, and then repurchasing it. This would reset the basis. What are the issues I need to consider?
By selling stock at a gain and then buying it back at the current price, you create a new basis in the stock. Because the shares are sold for a gain, there is no wash sale to worry about. The main reason for selling would be to avoid higher capital gains tax rates in a future year and the new Medicare surtax on net investment income. Compare this technique to tax-loss harvesting, in which stock is sold at a loss (without repurchase) to have future losses that can be netted against gains (another year-end planning strategy).
Example: You own company stock worth $100,000. The tax basis is $60,000. If you sell it now, you have $6,000 taxes on a $40,000 gain (at the current 15% capital gains rate). If you buy the stock back at same time, you obtain a $100,000 basis for a future sale.
Before you decide to do the same type of transaction, consider these issues in the situation presented by the example above:
- Check the size of capital-loss carry-forwards or losses from this year. Depending on your prior tax-loss harvesting, you may have $40,000 in losses to net against gains. If so, you can wait on a sale until the future, as you would not be paying any tax on gains up to that amount.
- Decide how you will pay the taxes and think about alternative uses of that money.
- Individuals who may be close to death should consider that the step-up in basis which occurs at death eliminates entirely the tax on the gain (i.e. you would want to wait on the sale).
- Think about whether a sale would trigger an unwanted disqualifying disposition for shares acquired through an employee stock purchase plan or incentive stock options.
- Remember that insider-trading rules and company blackouts may prevent sales and purchases. Unless you already have a Rule 10b5-1 plan in place, best practices for these plans usually require more than a few weeks to elapse between the time of plan setup and the first sale under the plan.