Something interesting happens to a lot of our clients when their companies IPO: they find themselves stuck in the highest tax bracket, no matter what they do. For at least a year. Maybe even two. ????️ ????️
And that wouldn’t be so bad if the stocks that vested at the IPO and after that did well. But in 2019, a lot of stocks from IPOs traded at or below the list price after their lock-up.
Yeah, not good. ???? Suddenly they’ve got to pay more taxes on a “value” that’s not actually worth what they’re paying taxes on.
And normally, we can play around with selling stock options to help people reduce their taxes or stay within a tax bracket that isn’t quite as high.
But what do you do when you’re stuck paying taxes in the top bracket no matter what? Like our client who had yearly wages of $1,481,000 last year, that was mostly from the double-trigger RSU he’d built up by working there for so long. ????
And then next year, even with the lower share price to reflect what’s happening in the market, is RSU vesting will put him at $457,546 from RSU alone. Add his salary on top of that, and he’s firmly in the top federal tax bracket with no chance of being taxed any lower. ???? ????
So… what should his sales strategy be? Especially now that taxes don’t matter, because he’s paying the top price anyway?
How to Sell Shares When You’re In the Top Tax Bracket
First of all, your taxes are going to be really, really high, and you’ll most likely run into issues with standard withholding on supplemental wages. (RSU are considered supplemental wages.) Until you reach $1 million in RSU earnings, your company may only withhold 22% of income on that for taxes, but your tax rate will be 37%. So we know for sure you’ll need to sell at least enough of your shares to cover that 15% tax difference. ????
But after that guideline, there’s no clear-cut plan to follow. Most of the time, employees decide what to sell based on their tax situation–like selling as much as they can before they hit the next tax bracket. But since you’re already in the highest tax bracket, there’s no such threshold to use as a guideline.
What you sell isn’t directed by your tax bill, and instead becomes directed by things like how you expect the stock to do over time, and what your net worth goals are.
Selling Stock Options to Obtain a Net Worth Target
If you don’t have any specific goals to fund (such as buying a house), we recommend creating a plan to sell your stocks based on a net worth target. ???? A good rule of thumb to start with is to have no more than 50% of your net worth tied up in your company’s stock options, RSU, or shares.
So let’s say that including your stock options, shares, and RSU, you have a net worth of $3.1 million that breaks down as follows:
- $650,000 in shares from RSU vesting
- $1,600,000 in shares from previously-exercised ISO
- $500,000 in vested stock options
- $350,000 of other assets
With that breakdown, your shares, RSU, and stock options total $2.75 million, which is 89% of your net worth… quite a bit higher than that 50% or less guideline.
Your goal, then, would be to decrease your company’s stock from 89% to 50% by selling stock options. This way, your net worth is not so highly dependant on the ups & downs of your company’s stock prices.
So – how do you do that quickly? Do you do it all at once? In one year? Over the course of three years?
It’s up to you. If you’re not confident in the company’s stock doing well, sell ASAP. On the other hand, if you think it might do well, create a plan to sell down to 50% that lasts longer than one year, but is less than five years. If you decided to sell over the course of three years, that means you’d sell 13% each year.
So… What Do You Sell & When Do You Sell It?
Fortunately, we’ve put together an in-depth guide on selling stock options & when to sell them here: When to Sell Stock Options: Learn Stock Option Type & Time to Sell.
But to save you some time, here’s a brief run-down:
1. Sell All Future RSUs as They Vest
The first thing you need to do when you want to diversify your portfolio (reduce your company’s shares in your net worth to 50% or less) is to quit “buying” your company’s shares. And holding on to RSU after they vest is basically like buying them. So don’t do it.
In fact, if you do nothing else in regards to selling your shares, at least do this. Just know that this won’t do much to reduce the percentage of your net worth invested in your company, so you’ll have to do more.
2. Match Gains in Long-Term Capital Gains Shares to Losses in RSU Shares
With the poor performance of a lot of recent IPOs, losses when selling RSU shares is a thing. A lot of employees are facing massive capital losses after their RSU shares got released at IPO, but the price goes down during their six-month lock out period when they can’t sell. But they’re still stuck paying taxes at the IPO price.
To top it off, you may also be dealing with wash sale rules. When you sell your RSU at a loss, but you have more RSU that vests 30 days before or after selling at a loss (like if you have RSU that vests every month), your losses are disallowed. Which is a huge bummer. ????
If you have long-term capital gains shares, you can match those gains up against RSU losses. By doing this, you’ll only pay capital gains tax on realized gains after any realized losses (like your RSU losses) are accounted for. This means you can get closer to that 50% or less target, free up some cash, and not pay any more in tax.
3. Sell More RSU Shares
Even if you have to sell at a loss, RSU shares are almost always your first priority when it comes to selling stock options. They’re taxed as ordinary income when they vest, so you’re paying taxes on them whether you hold onto them or not… and they often carry the highest cost basis, meaning there are fewer tax implications associated with selling them.
4. Sell Long-Term Capital Gains Shares
If you’re in the top federal tax bracket for ordinary income, it means you’re also in the top tax bracket for long-term capital gains. However, the percentages you pay for ordinary income and long-term capital gains are different. (You’d pay 37% on income, but only 23.8% on your long-term capital gains.
Clearly, if you’re already going to be paying more in taxes, it’s better to only pay 23.8% than 37%, right?
So if you still need to sell more, sell shares that qualify for long-term capital gains from the past exercise of stock options.
NOTE: if the shares are from ISO (incentive stock options), make sure you calculate your AMT (alternative minimum tax) cost basis and account for any MTC (minimum tax credit) you can use.
5. Nonqualified Stock Options (NSO)
NSO are taxed at exercise, as ordinary income… but only on your “gain” when you buy them. Basically, you pay regular income tax on the difference between your exercise price and the market price on the date of exercise.
Your best choice with NSO is to wait until the market hits a stock price you like, and then exercise and do a same-day sale. Do not exercise and hold with NSO. However, if you plan to sell off your stock options over a few years, you could save your NSO to be one of the last things you sell. This way, you delay the tax bill you’ll have to pay, and there’s a chance that the stock price may go back up, making you more money in the end. (Not to mention, your tax bracket could drop and give you the opportunity to exercise at a lower tax rate.)
6. Incentive Stock Options (ISO)
The last thing to exercise and sell are ISO. In an ideal world, you’d exercise your ISO in January, hold for one year, and then sell. Reason being, if you exercisel in January and hold for one year, the stock count as long-term capital gains, and will be taxed at a lower rate.
But also, January gives you a unique advantage, because if you exercise in January, you don’t have to pay taxes until the following April, giving you 14-15 months between when you exercise and when you pay the taxes. (Giving you plenty of time to prepare for your tax bill.)
Just make sure you calculate your break-even price, and how far the price of the stock can go down before you lose the advantage of long-term capital gains. If the stock starts doing poorly, you may have to sell your stock before the one-year mark.
Create a Plan & Stick to It
The most important thing around selling stock options is to create a plan that’s sustainable and easy for you to execute on. If you’re not well-versed in the world of buying and selling your company stock with your stock options, the help of a financial planner can go a really, really long way in setting you up for success.
We’ll help you use the prioritized list above to decide what to sell and when, and we’ll also help you pivot your plan if unexpected things happen with your company’s stock price.
As a rule of thumb: always remember that there’s nothing wrong with selling more… and the most important thing is that you get a sell price you’re happy with. Any time you like the price, sell.
And to make sure you get the most out of your IPO situation, continually-vesting RSUs, and creating a net worth portfolio you’re proud of, book a call with me today to see what we can accomplish.
