This year may be like no other, but if you’re an employee who receives equity compensation, you can’t ignore the importance of year-end financial planning to get the most out of that benefit.
The end of the year is a great time to review what you’ve received or vested during the year. Considering your equity compensation along with your overall financial situation gives you the opportunity to make smart decisions that could affect your investments, income tax and cash flow for years to come.
Planning for equity compensation at the end of the year does not reflect an arbitrary timeline, but a legitimate need. Your tax obligations, cash flow and investment risks could all be affected by actions taken before the close of business on Dec. 31.
Choices about your company stock and stock options should not be spur-of-the-moment decisions. Realistically, it’s unlikely most plans coming into 2020 anticipated the financial impact of a pandemic. But even if you updated your plan during the year, market volatility, a prolonged recovery and other potential issues should be factors in sound decisions made at the end of this year. Equally important, year-end decisions involve tax planning, particularly around exercising your incentive stock options and the alternative minimum tax.
Review your current equity compensation plan: Beyond your goals and plans, your company’s equity compensation plan — and potential changes or thresholds — should also be part of your review. For example, some companies may have concerns if their industry was hard-hit by the Covid-19 crisis.
Take stock of what you’ve accumulated so far and any stock options or grants that may arise if no changes are made. Then, work with your financial advisor to coordinate your equity compensation with your long-term financial plans and near-term obligations.
One priority may be evaluating your AMT situation. You may pay AMT based on the value of the bargain element when you exercise incentive stock options. If you exercise ISOs but don’t sell them in the same calendar year, the difference between the price you paid and the options’ value when they were exercised is treated as income in calculating your AMT. However, if you exercise your shares and sell them in the same year, the difference is not counted as AMT income.
To avoid a large (or any) AMT obligation, it’s important to consider your ISO moves carefully. One possibility is exercising options early in the year so you can time the sale based on the stock performance at any point in the year.
Conversely, some exercise options at year-end, when they can more accurately gauge their income for the year and potential tax obligations. This may help you avoid situations where you exercised early in the year and the stock price dropped between that time and Dec. 31, resulting in a greater tax burden.
Another option is taking advantage of the AMT crossover point, when you can exercise those options but pay no AMT.
The AMT total is derived from a secondary tax calculation when you actually file. This is the tentative minimum tax. Taxpayers pay this amount or their regular tax calculation, whichever is higher. If the tentative tax amount is higher than the regular, you owe AMT. Determining your best timing is a critical part of year-end incentive stock planning.
Year-end is also the perfect time to choose whether to keep your accumulated shares or sell them, including vested restricted stock and exercised non-qualified stock options. Depending on your long-term financial goals, you’ll want to evaluate the market price at which the shares were vested with you and the company’s current performance. For tax purposes, when restricted stock units (or awards) vest or you exercise non-qualified stock options, the value is taxed as ordinary income.
Another planning consideration is whether your overall financial health is too heavily weighted toward your current employer. The options, incentives and grants can be great. However, if you still work there, you may not want to be too heavily invested — income and investment wise — in one firm.
This year has seen tremendous stock market volatility, and planning for 2021 amid a global pandemic and an uncertain political climate requires a lot of assumptions.
But one thing is certain: evaluating your expected tax situation next April, including your equity compensation and 401(k) plan deferral rates, with the help of an advisor can give you a chance to make positive financial progress while there is still time to affect the results.
— By Daniel Zajac, partner at Simone Zajac Wealth Management