Given the likelihood of higher US tax rates starting in January 2013, you’ll want to review the way you manage your compensation. Your cash bonus, executive stock options and large holdings of company stocks deserve careful review, as my colleague Richard Weaver explains below.
Three Ways to Save
If your company normally pays each year’s annual bonus in the following year, you could ask for a change in policy—at least for 2012. Unless Congress passes new tax legislation before year-end, the top marginal federal income tax rate will climb from 35% this year to 40.5% in 2013. Persuading your company to pay this year’s bonus before December 31 could save you as much as $5,500 for every $100,000 you receive.
A similar argument can be made for executive stock options. Nonqualified stock options are taxable at ordinary income rates when exercised. Our research has identified the optimal time to sell your options based on your company characteristics, the time until expiration and how deep you are in the money. If your options are in the exercise zone, you’ll prefer to do so in 2012.
Our research also helps identify the optimal amount of company stock to diversify. If you are in the wealth accumulation phase of your career, you’ll want to calculate your core capital requirement, the amount of money needed to endow retirement. Your core capital requirement can be substantially lower when it’s in a well-diversified portfolio rather than concentrated in a single stock. To the extent that you have additional capital, holding the single stock may be beneficial for wealth transfer or charitable planning.
If the shares have appreciated significantly since you acquired them, you’ll face a large bill for capital-gains tax when you sell. The highest federal rate for long-term capital gains, currently 15%, will jump to 23.8% in 2013, so selling in 2012 would be advantageous.
To quantify the benefit of acting now, we compared selling and diversifying in 2012 to holding the stock and selling later at the higher rate. An executive with $1 million of zero-basis single stock who sells in 2012 and reinvests in a diversified global equity portfolio will have approximately $1.1 million in five years in the median case. This is some $183,000 more than the outcome of selling the stock five years hence at a federal capital-gains tax rate of 23.8%, as the display below shows. The odds of being better off because you act now are about two in three—not a sure thing, but certainly worth considering.
Under normal conditions, the standard advice about taxes is not to pay them until they’re due, but in the current situation, that principle does not apply. Today, where possible, accelerating tax payments into 2012 is often the better choice.
The views expressed herein do not constitute, and should not be considered to be, legal or tax advice. The tax rules are complicated, and their impact on a particular individual may differ depending on the individual’s specific circumstances. Please consult with your legal or tax advisor regarding your specific situation.
The Bernstein Wealth Forecasting System, SM driven by the Capital Markets Engine, uses a Monte Carlo model that simulates 10,000 plausible paths of return for each asset class and inflation and produces a probability distribution of outcomes. The model does not draw randomly from a set of historical returns to produce estimates for the future. Instead, the forecasts (1) are based on the building blocks of asset returns, such as inflation, yields, yield spreads, stock earnings and price multiples; (2) incorporate the linkages that exist among the returns of various asset classes; (3) take into account current market conditions at the beginning of the analysis; and (4) factor in a reasonable degree of randomness and unpredictability.
Daniel B. Eagan is the Head of the Wealth Management Group, and Richard L.N. Weaver is a National Director specializing in advanced planning techniques for corporate executives, both at AllianceBernstein.