Year-End Planning

Every year in February, after the W-2s and 1099s have arrived, we get tax-planning calls. Of course, by then it’s too late. The time for tax planning is before the year ends.

Under the American Taxpayer Relief Act and the Affordable Care Act, some major modifications of tax law took effect in 2013, and this is the fourth year since their enactment. These five points summarize the changes:

The top tax marginal bracket is now 39.6% for single filers who, in 2017, have adjusted gross income (AGI) above $418,400 (above $470,700 for joint filers).

Long-term capital gain (and qualified dividend) rates have been raised to a top rate of 20% for those same earners who have, in 2017, AGI of more than $418,400 (more than $470,700 for joint filers).

The Medicare tax, normally 1.45%, is 2.35% for single filers with AGI above $200,000 (above $250,000 for joint filers).

A Medicare surtax of 3.8% applies to the lesser of either total net investment income or modified adjusted gross income above $200,000 (above $250,000 for joint filers).

Finally, a phase-out of itemized deductions and personal exemptions applies to taxpayers who have, in 2017, AGI of more than $261,650 (more than $313,800 for joint filers).

Continuing Market Vigor Presents Opportunities

2017 was another volatile year for equities. Back in 2008 and early 2009, the steepest market decline in 75 years wiped out many people’s retirement savings, dropped many stock plan participants’ options out of the money, and significantly reduced the value of rewards deferred or granted during the prior several years. The rebound through most of 2016 partly reversed some of those losses, and for some people, the continued rally in the first part of 2017 produced significant short-term gains in grants received during those down years. October saw a return of stock values for some industries. Banks and energy are notable exceptions, but some tech industry stocks have had a good year in spite of the ups and downs. Between now and the end of the year, it is important that you once again carefully examine your employee stock holdings for the kind of tax-saving and portfolio-management opportunities that volatility can present.

Again this year, many market participants’ experience may not be relevant to planning for the future or dealing with what has happened in the recent past. Market-behavior assumptions, developed during the post-1945 economic expansion of the US and based on research, opinion, and empirical experience, is proving in many cases to be inadequate for explaining what happened or what may be the best choice of action in the slow-motion recovery we have experienced over the past decade. Now that more than seven years have elapsed since the credit crunch and market crash, past performance numbers represented in funds, indexes, and other market measures are going to look very attractive. Don’t be fooled into believing that a recovery from historically volatile lows to where we are now is a pattern that will be perpetuated indefinitely. Extremely low interest rates, the slow growth of consumption, flat wage growth, and a glut of low-cost global labor all point to historically slow economic growth that will probably be matched in financial markets generally. So we shouldn’t assume that financial-planning assumptions based on data from the post-oil-embargo 1970s through the beginning of the 21st century will translate to this environment. Lower returns and longer life spans will make it more important than ever to adhere to conservative principles of tax management and portfolio balance that we know make common sense in any market. We discuss these in this chapter.

NQSOs And Restricted Stock: Little You Can Do

The spread between the exercise price and the market price of NQSOs is taxed as ordinary income at exercise (as is the value of restricted stock at vesting), and the tax is fixed on that date. If you know your tax bracket will be higher this year, because an exercise will push your marginal income into the highest rate, you may want to consider straddling years for your NQSO exercise to take the compensation income in the lower-tax year, going just up to the 39.6% threshold but not over it. With restricted stock or restricted stock units, you have no flexibility in choosing the tax year, as the vesting date is set.

With NQSOs, unlike with ISOs, nothing at year-end can change the tax impact of your exercise earlier in the year, regardless of whether your company’s stock price has dropped (or risen) since you exercised. After you exercise and hold NQSO stock, the holding period begins, and it is simply stock with no special tax status. Evaluate it like any other investment (a similar analysis applies to restricted stock after it vests). When you sell the shares, the rules of capital gains tax apply.

Maxed Out On Social Security?

For NQSO-holders who have already “maxed out” their Social Security tax by earning over $127,200 in 2017, any additional exercises before the end of the year will occur without Social Security withholding, letting you keep an additional 6.2% of the spread. Remember that, as stated above, the Medicare tax has risen to 2.35% for single taxpayers earning over $200,000 ($250,000 for married joint filers), and a Medicare surtax of 3.8% on investment income also applies to those same taxpayers.

Planning Ideas

Special year-end tax moves for option holders generally apply more to incentive stock options (ISOs), which I discuss later in this chapter. With these thoughts in mind, add the following items to your planning between now and the end of the year. (Note that the tax issues and treatment discussed here are similar for stock appreciation rights.)

Taxes should not drive decisions. Remember to never base any decisions solely on taxes or expected future tax rates. If in December you sell at $20, merely to “take advantage” of your loss for stock exercised at $30 per share earlier in March, you lose the opportunity for future appreciation in the stock. Should it double to $40 by February, you will miss out on a gain of $20 per share.

As I have pointed out previously, you should almost never make exercise or sale decisions based solely on tax considerations. No advisors know with certainty what tax rates will be in the future.

You should always base exercise decisions on a determination that your company stock has peaked, on a need for money, or on a desire to seek diversification. You may come to these conclusions by a number of paths but “buy low, sell high” is still the only way to make money in the market. Yes, your profits will be taxed, but you’ll never get rich by taking losses! You may reduce your income taxes with a year-end sale, but you eliminate your real opportunity to make money over the long run.

Make sure you can pay your taxes. Always double-check that you will have the money to pay your taxes. If you exercised NQSOs, you may owe some income tax beyond what your company withheld at exercise. When you exercise an NQSO, your company withholds federal, state, and Social Security taxes. However, most companies withhold federal tax at only the minimum required federal supplemental income withholding rate of 25% (39.6% for total yearly amounts of supplemental income5 in excess of $1 million). Similar withholding rates apply to the value of restricted stock at vesting. If you are in the 35% or higher tax bracket, you may owe the additional 10%–14.6% with your tax return (or through estimated taxes), unless you’re fortunate enough to have made more than $1 million in supplemental income.

In addition, if you were not an employee of the company when you exercised NQSOs (e.g. a consultant or contractor), the company might not have withheld taxes at all. Instead, it might have just given you an IRS Form 1099-MISC that reports the income. Ask your accountant to estimate your tax liability and then make sure you can cover it. This may mean you will need to pay estimated taxes and/or sell more stock this year, but at least you will be confident of your ability to pay taxes.

Sell losers. Despite the market recovery, you may still have some stocks whose prices are below what you paid for them, perhaps substantially. Consider selling stocks that have lost value since purchase, but only when you expect the stock to continue to lose value. The best reason to sell a stock is that it’s no longer a good investment. You may even want to sell the stock if you think it is not going to appreciate as quickly as alternative investments. If you expect only a small recovery in your stock but believe the market is going to appreciate substantially, sell, harvest the losses, and purchase something else.

Know the rules on loss deductions. Sell if you can deduct the loss. If stock acquired from an option exercise or restricted stock/RSU vesting is now worth $5,000 less, the sale will generate a $5,000 capital loss. This may reduce your tax liability, but the amount of the deduction depends on the rest of your tax situation, including the gains and losses from other stock sales and loss carryforwards from prior years.

The tax law says you can offset losses only against the same type of income. This means you cannot use a $5,000 capital loss to offset $5,000 of your salary. However, you can use the $5,000 capital loss to offset a $5,000 capital gain. There is one small exception to the “matching” rule. You can use up to $3,000 of capital loss to offset $3,000 of ordinary income, carrying forward any unused losses to next year. Therefore, if you sell only enough stock to generate $3,000 of capital loss, you will most likely get a deduction for the full amount. If it turns out that your tax rates are eventually higher in 2015 and beyond, consider one “benefit” you may not have thought about: higher rates make loss carry-forwards more valuable if they are used to offset ordinary income. Current tax rules allow write-offs against ordinary income up to $3,000. In the top 39.6% bracket, the offset will be worth $1,188.

American investors lost $5 trillion in the market decline of 2008. If you are still carrying forward market losses, consider taking capital gains by year-end to use them up if you think your company’s stock is overvalued or you are over concentrated in it. Many of my clients whose restricted stock and restricted stock units vested in 2007 and 2008 are carrying those shares at a tax basis that is still above today’s market price, while shares that vested in 2009, early in that year, are up substantially. We will be paying close attention, as we approach year-end, for an opportunity to sell the appreciated shares and an offsetting amount of shares from previous vestings, at a loss, in order to diversify, raise cash, and position ourselves for what may come.

Sell if you need money. Even with the tax changes, your stock gain at sale is taxed at the long-term capital gains rate of only 15% or 20% (depending on your yearly income) when you have held the shares for more than one year. Capital gains are still preferable to ordinary income.

Should you need money to pay for your child’s university tuition in January, sell stock. Although the market may be poised for a big jump, don’t wait. If it drops instead, you may not be able to pay the tuition costs. Always keep your short-term cash needs out of stocks so that you can ride through any short- or long-term drops in the market. While we’re on the subject of college tuition, the American Opportunity higher-education credit, offering up to $2,500 annually per student for four years of college, covers tuition, room, board, and books, and it has been extended through 2017. The credit begins to phase out at $80,000 of AGI ($160,000 for joint filers). If the credit is more than your income-tax liability, 40% of it is refundable. Also, the full credit is allowed against the AMT.

Consider gifting stock to relatives in low tax brackets. You may make annual gifts of $14,000 ($28,000 if you split the gift with a spouse) to any number of recipients without either affecting any portion of your lifetime gift tax exemption or paying gift tax. Financial advisors often tell high-net-worth clients with substantial estates to consider making annual stock gifts before the end of the year, up to these amounts. Depending on the size of your estate at death, a strategy for making lifetime gifts can reduce your estate taxes, particularly if the value of the shares rises significantly after the gift. High-net-worth individuals should consider a grantor-retained annuity trust for their company stock.

The long term capital gains tax rate on people in the 15% tax bracket is to 0%. If you have adult children, who file their own tax returns and whose income is likely to be in the 15% tax bracket in 2017, they will pay 0% tax on long-term capital gains that don’t cause their income to rise to the next bracket. Consider an appreciated shares gift to them of up to the annual gift limit before year-end. Gifting highly appreciated ISO or vested restricted shares you held on to can be a wise way to remove value from your taxable estate and will allow the lower income recipient to sell 366 days after your gift and qualify for the 0% rate.

Alert: The “kiddie tax” (i.e. your tax rates, not your children’s) will apply to stock sales by your children under the age of 19 as well as college students under 24 unless the students provide over half of their own financial support from earned income.

Retirement planning: it’s not too soon to plan for future years. If you have additional compensation income this year from your stock option exercise or restricted stock/RSU vesting and are not eligible to fund a Roth IRA or deductible IRA, you may want to consider funding a nondeductible traditional IRA. Even if you are covered by a retirement plan, such as a 401(k), at work, you can still take a full IRA deduction in 2017 if your modified AGI is less than $62,200 ($99,000 for married couples filing jointly). A partial deduction is allowed until your AGI reaches $72,000 ($119,000 for married couples filing jointly).

For the tax year 2017, the contribution limits for a Roth IRA are $5,500 for a person under 50, and $6,500 for a person who is 50 or older before the end of the year. To be eligible for maximum contributions in 2017, married joint filers must have MAGI of $186,000 or less, and single filers must have MAGI of $118,000 or less. The phase-out range for partial contributions extends from there up to an income ceiling of $196,000 for married joint filers (up to $133,000 for single filers), beyond which contributions are not allowed.

The income limit on conversions from traditional IRAs to a Roth IRA was eliminated under the phased-in rules of the Tax Increase Prevention and Reconciliation Act of 2005. This tax law also eliminated the rules that prohibited married separate filers from converting traditional IRAs to Roth IRAs. Therefore, more people than ever before are eligible to make Roth IRA conversions. If you are already contributing the maximum to your 401(k) at work, now may be a good time to consider making a nondeductible contribution to a traditional IRA with the expectation that it can be converted to a Roth later. If you have not been making IRA contributions, because of the income restrictions, perhaps it’s time to take a look at nondeductible contributions as part of your retirement savings plan.

When you do convert your traditional IRA to a Roth IRA, you will owe ordinary income tax on the value of any tax-deductible IRA (speak with your tax advisor about the related calculation). Income from your stock compensation can help you pay this additional tax.

Year-End Planning For ISOs

Year-end planning is especially important for anyone who has exercised incentive stock options (ISOs) during the year. Unlike nonqualified stock options (NQSOs), ISOs are quite often exercised with the intention of holding the stock to qualify it for long-term capital gains treatment on the full gain over the exercise price. Because of the opportunity presented by the dramatic drop in stock prices during 2008–2009, alert employees may have jumped at the chance to exercise ISO grants that were made when the company’s stock price was abnormally low. If you are still holding those shares, it may be time to decide whether the time is right to take long-term gains.

This year’s volatility may have you thinking that a market top has been reached. If your confidence about your company’s outlook has risen, you may be thinking about exercising and holding now. The market’s performance since the credit crunch may cause you to consider locking in your gains on options you exercised earlier. Either way, below are some things you should think about if you have ISOs or have exercised ISOs during the past. (If you have NQSOs or restricted stock, see chapter 7 for related year-end ideas.)

Determine your Alternative Minimum Tax (AMT) opportunity. The American Taxpayer Relief Act (ATRA) permanently indexed the AMT for inflation. The amount of income exempt from the AMT in 2017 is:

$54,300 for single and head of household filers

$84,500 for married people filing jointly

There are two AMT brackets. In 2017, the threshold where the 26% AMT bracket ends and the 28% AMT bracket begins is $93,900 for married couples filing separately and $187,800 for people in any other filing status. The Tax Cut and Jobs Act of 2017 (TCJA) will dramatically alter the AMT in 2018. The new rules increase the 2018 AMT exemption to $70,300 for single filers and $109,400 for those filing jointly. The new phase out of the AMT exemption creates a zone where the top AMT rate rises as high as 35% and is adjusted upward to $500,000 for individuals and $1,000,000 for married couples for 2018 and beyond.


No matter what the rate or level of exemption is, the AMT presents an opportunity. If you have not already exercised any ISOs this year, ask your accountant to determine your AMT spread. This spread is the difference between your ordinary tax and your AMT obligation. Seemingly benign tax deductions like medical expenses, state and local taxes, mortgage interest, and miscellaneous itemized deductions can trigger the AMT, along with the spread at ISO exercise.

If you calculate that your 2017 ordinary tax is greater than your AMT, you have an opportunity to exercise some more ISOs without owing any additional tax. If you can’t use all your AMT credits, look to 2018. Under the new JCJA rules, many taxpayers will be able to use up most of their remaining AMT credits. This is because a higher AMT exemption together with a bigger gap between the household’s regular and AMT tax, provides more room to claim the carry-forwards.

Example: Your accountant says that your ordinary tax is $70,000 and your AMT is $60,000, meaning you have a $10,000 AMT spread. You can generate an additional $10,000 of AMT without paying any additional taxes. Assuming you are in the 28% AMT bracket, you may be able to exercise ISOs with a spread of $35,700 without paying any additional tax (this generates $9,996 of AMT income). The exercise begins your holding period to qualify for long-term capital gains. As a result, you will be able to sell the stock after one year from exercise (and two years from grant) and pay only the lower long-term capital gains tax on the full increase over your exercise price.

This may not be to your advantage if you currently have an AMT credit carry-forward from last year. (Of course, you should confirm any tax calculations with your accountant and other advisors.) However, the AMT spread often provides an opportunity to generate income without generating additional tax.

Make a decision about ISO stock that has lost value since exercise. While the market has recovered, not every stock is higher today than it was earlier in the year. If you exercised and held ISOs this year and the stock has dropped in value since exercise, you have to make an important decision. Should you sell the stock before the end of the year to eliminate the AMT, or should you simply sit still and hope the stock will recover?

Example: You have an exercise price of $10. You exercised your option on January 15 of this year, when the stock had a value of $50. You generated $40 per share of alternative minimum taxable income (AMTI). If you are in the 28% AMT bracket, you will owe $11.20 per share of AMT (with an AMT credit to use in future years). You plan to hold the stock until January 16 of the next year. You intend to sell the stock and pay only long-term capital gains on the profit.

However, on December 1 the stock is trading at only $20 per share. If you sell the stock, your tax calculation changes substantially: selling the stock is a disqualifying disposition, and the gain is taxed as ordinary income. The gain, though, is limited to the difference between your exercise price ($10) and sale price ($20). You will have only $10 per share of ordinary income. If you are in the 35% top federal tax bracket you will owe $3.50 per share. The original AMT is simply eliminated.

You must make a decision. If you sell in December, you will have to pay only $3.50 of tax. If you wait until January of the following year, you will have to pay the AMT of $11.20. You will get a credit for some of the AMT, but it may not be easily usable. Therefore, you may want to sell in December to eliminate the AMT liability.

Of course, the numbers all change for the better if you do not sell in December and the stock recovers to $50 per share by early in the following year. Although you will still owe the $11.20 of AMT, you will make a lot more money by selling at $50 instead of at $20 per share.

In this situation, you should consider selling if you are concerned that the stock price may not appreciate, or if you do not have the funds to pay the AMT. If you have the money to pay the AMT and expect the stock to appreciate, waiting to sell may still be worth considering.

Evaluate your own ISO situation. It’s important to determine:

your AMT liability without a sale

your ordinary tax liability if you sell

how you will pay your AMT if you don’t sell

In addition, remember to factor in your confidence in the future value of your stock. If you think the stock is going to appreciate substantially, waiting is your best choice. Exercising ISOs early in the year to start the 12-month holding period gives you more time to watch the stock so that you can decide whether a disqualifying disposition is prudent.

Think tactically and long-term about year-end gifts of appreciated ISO stock. The long term capital gains tax rate on people in the 15% tax bracket was dropped to 0%. If you have adult children or retired parents, who file their own tax returns and whose income is likely to be in the 15% tax bracket in 2017 ($37,950 for single filers, $75,900), they will pay 0% tax on long-term capital gains that don’t cause their income to rise to the next bracket. Consider an appreciated shares gift to them of up to the annual gift limit ($14,000 per person, per gift) before year-end. Gifting highly appreciated ISO shares can be a wise way to remove value from your taxable estate and will allow the lower income recipient to sell 366 days after your gift and qualify for the 0% rate.

Beware of gifting ISO stock too early. Don’t get carried away by the holiday spirit! Gifting stock that is generated from the exercise of an ISO is considered a disqualifying disposition. If you have not met the required holding periods and you gift the stock, the gain at exercise is taxed as ordinary income. This includes gifts to charities, family members, or others. Therefore, you may not want to gift the stock until you have met the holding period.

Also think about AMT credits. If you must pay the AMT, you may be entitled to an AMT credit to use in future years when your regular income tax exceeds the AMT. Unused minimum tax credits are carried forward indefinitely. When this AMT credit is available, under the standard rules it can be used to reduce your regular tax liability only by the amount it exceeds your AMT liability.