By Chuck Steege. Whether planned or unplanned, retirement prior to age 65 may present an income gap until the qualifying age to receive pensions and Social Security. While stock administrators cannot offer financial planning advice, they need to know how taxation variables impact executives as they draw down company stock from a variety of accounts and compensation plans. The complexity surrounding stock-based compensation clouds the dilemma: Which funds should be drawn from to optimize the performance and minimize the tax consequences?
Analysis of Stock-Based Compensation
Depending on the type of compensation, timing and account type, company stock is subject to a wide variety of tax treatments. Since taxes matter, it’s important to consider the distinctions:
Stock Options – ISOs and Nonqualified Stock Options
Any gain from nonqualified stock options (NQOs) is considered ordinary income.
Less common option awards are Incentive Stock Options (ISOs). With proper planning, the ultimate difference between sale price and the ISO strike price may be treated as a capital gain.
Restricted stock is taxed at vesting, which makes restricted stock a favorable source of funds to bridge the retirement gap. In certain situations, it may be appropriate to consider making a section 83(b) election to notify the IRS of any decision to accelerate payment of ordinary income taxes at grant date and not vesting date.
Performance shares are taxable when they vest, making them a good source of income at retirement. One caveat: Beware of company-mandated post-vesting holding periods which may prolong the executive’s ownership requirements on performance shares.
Restricted Stock Units (RSU) and Performance Stock Units (PSU)
Both RSUs and PSUs are released to the executive only when they vest, which is often tied to tenure. They can be good sources of income at retirement because they’ve been taxed when they vest.
Stock Appreciation Rights and Phantom Stock
Stock appreciation rights (SARs) offer a bonus equal to the appreciation in the company’s stock, usually over a vesting period of several years. Phantom stock is a promise to pay a bonus equal to the value of a company’s stock or an increase in the value of the stock over a fixed period of time. These two forms of compensation are similar. As with phantom stock, the SAR is normally paid out in cash, but it could be paid in shares.
In the hierarchy of assets from which to draw, it is best to withdraw the “already taxed” assets before tapping pre-tax assets such as retirement plans. Even though you cannot offer advice to participants, here are five general rules of thumb for accessing retirement income that you should understand.
- Withdraw already-taxed assets first. Restricted stock, performance shares, RSUs and PSUs are ideal for drawing down in retirement. They have already been taxed at vesting.
- Live off lowest earning assets, then higher earning ones. Lowest earning assets may not include company stock at all; more likely they include bank accounts, CDs and money market accounts.
- Leverage assets whose sales are subject to capital gains first; that will cost less in taxes than assets subject to ordinary income taxes. As an example, with proper planning following an exercise, any difference between the sale price and the ISO strike price may be treated as a capital gain.
- Live off taxable accounts first versus tax-exempt assets.
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Stock proceeds withdrawn from most retirement accounts will be taxed as ordinary income and should be tapped last unless required by required minimum distribution.
- Retiring executives should seek professional guidance from their accounting firm or financial advisor to develop a plan to optimize their stock-based compensation to replace earned income.
For more information, please consult our white paper, The Great Drawdown: How to Optimize Stock-Based Compensation for Planned or Unplanned Retirement.
About SFG Wealth Planning Services, Inc. SFG Wealth Planning Services, Inc., based in Philadelphia, is a national financial planning service for corporate executives. Founder Charles “Chuck” Steege, CFP®, CEP, CKA is a Financial Advisor to senior leaders of public companies. He helps executives unlock the value from their varied and complex equity awards by combining his experience as a financial planner and equity plan professional. Advisory services are offered through SFG Investment Advisors, Inc., a Registered Investment Adviser. The information provided herein is based on current tax law, which is subject to change at any time.
© 2017 SFG Wealth Planning Services, Inc., a service of SFG Investment Advisors, Inc. a Registered Investment Adviser. www.sfgadvisors.com