This is the first year-end season when taxpayers with stock compensation must consider the changes introduced in 2018 by the Tax Cuts & Jobs Act (TCJA). Fortunately, the new tax law doesn’t make any huge changes in the usual year-end steps that you and your financial advisor should consider when you have stock options, restricted stock/RSUs and company stock holdings.
However, there are some key points to know and discuss with your advisor. For example, the new 22% withholding rate on income from stock comp and cash bonuses (lowered from 25%) could mean you’ll end up with a big tax bill in April.
Two Major Types Of Tax Changes
“Tax reform” is the blanket term often applied to the TCJA, which made two major types of changes in the tax laws for individuals. In some areas, the TCJA made straight-up tax cuts. In others, it restructured or eliminated tax provisions. Each of those two categories affects your year-end strategies differently, as explained below.
Tax-Cut Provisions
The TCJA modified the income-tax rate and income ranges of each tax bracket, including the reduction of the top income-tax rate from 39.6% to 37%. However, we still have the same number of tax brackets (lucky seven), and the capital gains tax and the Medicare surtaxes remain unchanged.
What this means: Whenever you consider exercising stock options or selling shares at year-end (or recognize any extra income), you need to know your tax bracket. Even with the lower tax rates that took effect in 2018, you still want to consider the income thresholds that would trigger a higher tax rate and the Medicare surtax on investment income.
In general, you want to do the following multi-year planning, just as you did before the TCJA:
- Keep your yearly income under the thresholds for higher tax rates and know the additional room you have for more income in your 2018 and 2019 tax brackets.
- Recognize income at times when your yearly income and tax rates may, according to your projections, be lower.
Example: You’re a joint filer with $200,000 of taxable income in 2018 and projected taxable income of $180,000 in 2019, putting you in the 24% tax bracket. You have a $120,000 spread on your nonqualified stock options. By exercising just enough options in 2018 to generate $50,000 of additional income (giving you $250,000 for the year), you can then exercise the remaining options in 2019. This lets you avoid the higher 32% tax bracket and both the additional Medicare tax (0.9%) on the income at exercise and the Medicare surtax on investment income (3.8%) when you sell the shares.
| 2018 Salary | $200,000 | $200,000 |
| 2018 NQSO exercise income | $50,000 when exercised over 2 years | $120,000 when income in 1 year |
| Total taxable W-2 income | $250,000 | $320,000 |
| Marginal tax bracket | 24% | 32% |
| Medicare taxes at sale and exercise | no | yes |
The flat withholding rates for supplemental wages, including stock compensation, are tied to the seven income-tax brackets, so those changed too. For income up to $1 million in a calendar year, the withholding rate is now 22%. For amounts of income in excess of $1 million during a calendar year, the withholding rate is 37%.
What this means: The 22% rate of withholding may not cover all of the taxes you will owe on income from an exercise of nonqualified stock options (NQSOs) or a vesting of restricted stock or restricted stock units. You must therefore know the tax bracket for your total income and assess the need to (1) put money aside to pay the additional taxes with your tax return, (2) increase the withholding on your salary, or (3) pay estimated taxes.
Tax Reform/Restructuring Provisions
The TCJA significantly raised the alternative minimum tax (AMT) income exemption amount and the income point where it starts to phase out. This greatly alters the outcome of the AMT calculation for many taxpayers. The new tax law also imposed a cap of $10,000 on the amount of state and local taxes (SALT) available for itemized deductions, and it eliminated personal exemptions.
What this means: It’s much less likely that you will trigger the AMT with an exercise-and-hold of incentive stock options (ISOs), and if you did you will be able to recover it with the AMT credit more quickly than before. At year-end, you want to assess whether to sell shares acquired from an ISO exercise earlier in the year. You evaluate whether to sell those shares to avoid the AMT or exercise more ISOs up to the income threshold that would trigger the AMT. Because of the changes in the AMT calculation under the TCJA, you now have much more room to exercise ISOs and hold the shares beyond the year of exercise without triggering the AMT.
The TCJA also raised the standard deduction to $12,000 for individuals and $24,000 for joint filers. On your tax return, you can either take the standard deduction or itemize.
What this means: If you are holding shares that have greatly appreciated in value, donations of company stock, whether directly to a charity or donor advised fund (DAF), can be a tax-efficient way to both make the donation and get you over the $12,000/$24,000 point where it makes sense to itemize. If you’re not always over that amount, you may want to consider bunching donations together in a single year to exceed it.
Taxes Should Not Control Decisions
Tax reform should not be the primary factor in decision-making at year-end. In fact, tax rates in general should never be the only reason for exercising options or selling shares, or waiting to do so, at the end of the year. Instead, make investment objectives and personal financial needs, not tax considerations, the driver of your decisions.
For more ideas on year-end planning for employee stock options, restricted stock/RSUs, performance shares, or an ESPP, see the year-end-planning section of myStockOptions.com.
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