Did Your Company Stock Cause a Big Tax Bill?
Stock compensation is a valuable benefit, giving employees an opportunity to share in the success of the business while growing their personal wealth. However, along with the potential for financial gain, often will come large tax bills and even IRS penalties that can erode the benefit that you receive from your stock. Understanding the intricacies of income and capital gains tax on stock compensation is crucial to minimizing tax bills and IRS penalties.
In this guide, we’ll explore the two causes of tax on stock compensation and 8 strategies to reduce your taxes in the future. Whether you're navigating vesting schedules, contemplating stock sales, or seeking ways to optimize your overall tax situation, this comprehensive overview will give you the knowledge and tools necessary to make informed decisions about your stock.
What causes my tax bill?
There are two taxes on stock compensation: Income Tax when received and Capital Gains tax when sold.
- Income Tax: Each time your stock is vested, it is taxed as ordinary income just like getting a paycheck. The taxable amount is the value of the stock when it vests X the number of shares. Many companies offer a "Sell to Cover" option, where a portion of the shares you receive is sold to cover taxes. Many companies who use this system (including Amazon, Google, and Microsoft) use a default withholding rate of 22% regardless of the tax you owe. This can create surprise tax bills and IRS penalties at tax time.
- Capital Gains Tax: This tax applies when you sell your shares. The amount taxed is based on the growth of the stock price from when you received the shares. The tax rate varies, depending upon how long you've held the shares, with lower rates for shares that have been held for over a year.
Example – Income Tax
Katie works for Amazon and received four stock vests last year that totaled 1,200 shares. She selected the “Sell to Cover” option to pay her taxes on these shares, and Amazon used the default 22% to pay her taxes.
At tax time, Katie received a surprise tax bill of $15,900 plus an IRS penalty of $1,400. This happened because she is in a 32% tax bracket and the total tax bill on her stock was $50,880, but Amazon only withheld $34,980.
|
|
Shares |
Price at Vest |
Taxable Amount |
Taxes Paid (22%) |
Taxes Owed (32%) |
|
Vest 1 |
300 |
$100 |
$30,000 |
$6,600 |
$9,600 |
|
Vest 2 |
300 |
$140 |
$42,000 |
$9,240 |
$13,440 |
|
Vest 3 |
300 |
$150 |
$45,000 |
$9,900 |
$14,400 |
|
Vest 4 |
300 |
$140 |
$42,000 |
$9,240 |
$13,440 |
|
Total |
1200 |
|
$153,000 |
$34,980 |
$50,880 |
The taxable amount for vested stock is the value of the stock when Katie had received it which totaled $153,000. At 32% she owed $50,880 but Amazon only paid $34,980, so Katie must make up the difference of $15,900 at tax time.
Example – Capital Gains Tax
Katie decides to sell 600 of the shares she received last year. 300 shares are from vest 2 which she received over a year ago, and 300 shares are from vest 4 which she has not owned for a year.
At tax time Katie has a surprise tax bill of $5,640, plus a $500 penalty from the IRS. Since she got the stock in Vest 2 over a year ago, Katie owes the capital gains tax rate of 15% on the growth of this Amazon stock. Since vest 4 was received less than a year ago, she owes the higher income tax rate of 32% on the growth in this stock. The gain amount used in her taxes is calculated as the sale price of $180 minus the vest price of $140. To find the total gain, multiply the gain of $40/share by the number of shares sold (300) gives a $12,000 taxable gain for the sale of each vest.
|
(# of Shares) |
Sell Price |
Vest Price |
Capital Gain |
Tax Rate |
Tax Owed |
|
Vest 2 (300) |
$180 |
$140 |
$12,000 |
15% |
$1,800 |
|
Vest 4 (300) |
$180 |
$140 |
$12,000 |
32% |
$3,840 |
Now let's delve into the solution for this, and how to reduce your tax bills.
Strategies to reduce taxes and stop owing money at tax time.
The first step in organizing your taxes is to be sure that you are paying the correct amount and on time. These two strategies will do exactly that and stop future tax bill surprises and IRS penalties.
1. Estimate and Adjust Tax Withholding: Amazon, Microsoft, and most employers allow tax withholding on stock compensation to be changed from the default of 22%. This allows you to change the withholding to the correct amount and avoid tax surprises and penalties by paying on time. It is important to accurately calculate which tax withholding to use and it may need to be adjusted year to year.
Example – Adjust Tax Withholding
Katie decides to use strategy 1 for her stock compensation. She calculates her tax rate, which is 32%, and uses her Amazon employee portal to update her tax withholding on stock vests from 22% to 32%. She receives the same amount of stock as example 1, and her tax owed is $50,880. Because she increased her tax withholding to 32%, she automatically paid $50,880 and at tax time has no surprise taxes or penalties.
2. Make Estimated Payments: If you're facing capital gains taxes from stock sales, consider making estimated payments directly to the IRS based on the calculated tax bill. Tax withholding is not an option for stock sales but this method provides on time payment and prevents surprise tax bills and penalties.
3. Avoid Short-Term Gains When Selling Stock: Strategically timing your sales of stock can significantly reduce your tax burden. Selling a stock within the first 365 days of ownership will result in a higher tax rate than if it has been owned for more than a year. Stock sold after a year of ownership is taxed as a capital gain with a lower tax rate of 15% or 20%. The gain from a stock sold within the first year of ownership is known as a short-term gain and is taxed as income which has a higher tax rate than capital gains and can go as high as 37%.
4. Choose Tax Lots Carefully When Selling Stock: When selling stock, opt for shares with less taxable gain to reduce your tax bill. Each time a new set of shares vests it creates a new “tax lot” in your stock account. When selling stock select the tax lot with the highest received price, also known as highest cost basis. This will result in lower taxable gains from your sale. Over time, as you accumulate many tax lots, this strategy will become more impactful.
Example -Minimizing Taxes While Selling Stock
Katie is planning to sell 600 shares of Amazon. She reviews the tax lots and dates received for her stock. She makes sure to only choose shares that she received over a year ago to get the 15% tax rate. She finds one tax lot of 600 shares with a cost basis of $160. She sells her stock at $180/share, resulting in a capital gain of $12,000. This results in a tax bill of $1,800, which is far lower than the tax bill of $5,640 that she owed in the example shown earlier for capital gains tax.
5. Be Conscious of Tax Thresholds When Selling: Spreading out sales of stock over multiple tax years can help you to stay in lower tax brackets and therefore reduce your taxes. Multiple new taxes are added when certain levels of stock gains happen in a single year. NIIT of 3.8% starts at $200,000, the 7% WA state tax begins at $261,000, and the Federal gains tax increases to 20% at $518,900 of total income. Awareness of these thresholds and their yearly changes will allow you to plan your sales to minimize your taxes.
6. Harvest Capital Losses: If stock prices fall you may have an opportunity to use losses in your stocks to cancel out other capital gains and reduce taxes. When the stock price falls below the price that the share was received there is a loss. Selling these shares will realize losses which can be used to offset gains in the current year, be carried forward to use in future years, or you can deduct a portion against your ordinary income. If your goal is to realize losses to be used in your taxes, and you want to keep the stock shares, you are allowed to rebuy the shares 30 days after they are sold.
7. Gift stock to charity: Donating appreciated stock to charities instead of cash can provide significant tax benefits that include deductions for the full value of the shares and will avoid taxes on the gains. By gifting stock in years when you have a larger tax bill the value of the gift can be deducted up to a certain threshold to help reduce taxes. Another benefit of gifting stock is that the gain that would be realized and taxed if the shares were sold will disappear when gifted to a charity.
8. Increase 401(k) contributions: Consider maximizing contributions to your 401(k) to reduce taxable income. While stock compensation cannot be deferred into a 401(k) plan, increasing contributions of other income sources can help offset taxes from stock grants.
Conclusion & FAQ
These strategies will allow you to effectively manage the taxes on your company stock and minimize what you owe. I have seen the positive impact they have had for the taxes of many Amazon, Microsoft, Google, and other tech employees that I work with. One important thing to add is that the tax rules for stock compensation are changing yearly and are increasingly more complex. The strategies in this article are, generally speaking, timeless, but they may change. It takes an increasing commitment of time to self-educate and to stay on top of these changes but the reward for doing so will also grow as it allows for more complex and effective strategies for reducing taxes. I hope that you can use these 8 strategies to reduce your tax liability which will result in having a more financially successful life.
Garrett Grigas CFA
425-902-4840
FAQ
How do I know what tax bracket I am in? Your tax bracket can be calculated personally or by your CPA/Financial Advisor. It is usually done by taking last year’s income, then making any adjustments for projected changes in the current year, and comparing it to the Federal Tax Tables.
How do I make an estimated payment to the IRS? The IRS allows estimated payments to be made online, over the phone, or by mail.
What is the difference between the short-term and long-term capital gains tax rate? There are two separate tax tables used for short-term gains and long-term gains. When the stock has been held for less then a year and the gain is short-term, income tax tables are used:
When the stock has been held for more than a year and the gain is long-term, capital gains tax tables are used:
How can I realize stock losses, but then keep the stock? The tax rules allow an investor to sell a stock, realizing the loss, and buy back the same stock after waiting 30 days. If the stock is purchased again before 30 days have passed, a “wash sale” happens and the loss may no longer be used.
What happens if I harvest losses but don’t have any gains? Losses that have been realized but do not have any gains to cancel are used in two ways. First, up to a $3,000 of losses will be used as a deduction against normal income. Any remaining amount of loss is reported on the tax return and is carried forward to the following tax year when they again can cancel out gains or be used for a $3,000 deduction against normal income. This continues until they are used and losses do not expire.
What happens if I miss making my estimated payment on time? If estimated payments are missed, interest and penalties begin to accrue on the missed amount until it is paid. As a general rule, the sooner this is paid off, the better.
What is the penalty for missed tax payments? The penalty is generally .5% per month late + interest, which varies but is currently 8%.
Can I gift stock to individuals or only to charities? Stock gifts can be made to anyone but the tax benefits are only on gifts to 501c3 charities. When stock is gifted to an individual, any gain in the stock will be passed along with the shares, which they will owe tax on when sold. There may be a benefit if they are in a lower tax bracket.
Is it better to sell my stock immediately or hold onto it? This depends on the goal for that stock. If the stock will need to be sold to pay taxes or other near-term spending, it often makes sense to sell immediately to remove any uncertainty from market swings. A second reason to sell immediately is if there is a goal to diversify the stock into other investments.
Garrett Grigas CFA
425-902-4840