No matter what kind of stock options you have, there are two specific end results of every well-executed stock option plan: cash and taxes.
The sale and exercise of stock options will leave you with cash to be invested. Getting the cash in hand is only the beginning; you have to invest it strategically if you want to leverage this opportunity to grow wealth.
But in addition to that cash, you will owe taxes from your exercise.
Taxes are inescapable. In fact, you’ll spend more money on taxes in your lifetime than any other single line item in your budget.
We estimate that a couple in their early 30s, living in California, with $340,000 worth of household income and a net worth of $3.4 million (including stock options), will pay a total of $43.6 million in total taxes throughout their lives.
And you could pay even more in taxes if you fail to use a good stock option investment strategy to manage your tax burden.
The Biggest, Costliest Tax Mistake Most People Make
The thing is, to create a good stock option investment strategy, you need to think ahead and not just focus on what’s right in front of you.
What’s happening today is important, too — but you have to look up every once in a while and consider what’s coming up ahead.
That’s the biggest mistake most people make with their taxes, and therefore, with their investment strategy: they think about taxes one year at a time.
They often want to know how to reduce taxes now, as in the current year. The focus for most people is on the tax bill that’s coming up next — but they don’t think about taxes 10, 20, or 30 years from now.
So they don’t invest with taxes in mind, and they end up paying far more than they needed to do so had they just tweaked the strategy they used.
We can’t always do very much about taxes right this second. But, we can do a lot to save you hundreds of thousands on the millions of tax dollars you will have to pay over your lifetime.
How You Might Be Messing Up Your Stock Option Investment Strategy
Here’s what most people tend to do with their stock options:
They cash out those options. Then they pay the taxes. And finally, they put all the remaining cash in a taxable investment account and call it a day.
By doing this, you will be taxed on both your options and the event that triggered them (like an IPO or acquisition).
Then, you’re taxed on all the dividends and interest that money earns in your taxable investment accounts each year and on any future gains when you sell.
If you didn’t pick up on that, let me make it clear what this does: it saddles you with taxes, more taxes, and even more taxes.
So what are you supposed to do instead?
Think about dollar location when it comes to how you invest.
Dollar Location Is the Most Powerful Stock Option Investment Strategy You Can Use
Dollar location is a way of taking the cash you have from your stock options and placing that cash across different types of investment accounts.
There are 3 main types of investment accounts you can use:
Taxable Investment Accounts:
These can be Individual or Joint accounts, or part of a trust. The taxable investment account is the most common type, and is the one most investors and advisors default to if they don’t consider tax planning as part of their strategy.
But your dividends and and the interest earned will be taxed every year. Capital gains are taxed when you sell (which you can at least control the timing of, unlike when your dividends and interest earnings are taxed).
Tax-Deferred Investment Accounts
Tax-deferred investment accounts include vehicles like:
- Pre-tax 401(k)
- Traditional IRA
- Health Savings Accounts (HSAs)
- 529 Plans
- Deferred Comp Plans
When you invest cash in these accounts, you may receive a tax deduction on those contributions, and it grows tax-free until you take the money out of the account. At that point, you’ll be hit with ordinary income tax when you withdraw.
If you take money out of the account too soon (before you reach full retirement age for IRA and 401k), you could also face possible early withdrawal penalties.
Tax-Free Investment Accounts
Tax-free investment accounts are Roth accounts. When you invest your cash, you don’t get a tax reduction based on your contribution — but your money grows tax free, and is never, ever taxed again.
Now that you understand the different options, let’s look at how to fund these various accounts so you’re optimizing your dollar location strategy.
Different Ways to Fund Different Accounts
There are different ways to move cash into and between these different accounts, but most people only know the most common ways.
You might already know that you can:
- Max out your 401(k) contributions
- Make nondeductible IRA contributions
- Move money between IRA types with a backdoor Roth IRA conversion
But those are not the only ways to fund your accounts. Most people miss out because they simply don’t know the options.
That’s why it’s critical to work with a financial advisor, who does know the options — and who thinks about the tax implications of where all your dollars go.
If your goal is to dramatically reduce the total amount of taxes you pay over your lifetime, then you need to realize that every dollar not going to taxes is a dollar you can invest and grow.
You can do this by using your cash from your stock option exercise, and moving money over time. Gradually, you’ll want to move money from taxable accounts to tax-deferred accounts to tax-free accounts — and pay taxes when the tax rate is the lowest.
An Example of Dollar Location at Work to Save Taxes
Let’s assume you make $200,000 per year and your company just went through an IPO. After the event, you’re left with proceeds of $1 million after tax.
From your current job, you also have access to your pre-tax 401(k) and after-tax 401(k), deferred comp plan, and a health savings account.
What most people do is to max out their pre-tax 401(k) contribution, pay income taxes, and then use the rest of their salary to pay their living expenses. But you can be different.
You now have that $1 million in cash from an IPO — and instead of putting $1 million in a taxable account, you can:
- Put 25% of your income in your deferred comp plan with $50,000 located in a tax-deferred account.
- Make the maximum after-tax 401(k) contribution. The maximum after-tax 401(k) contribution will vary based on your employer match. It could be as much as $35,500.
- Start doing backdoor Roth conversions, to get $5,500 into a tax-free account each year.
Each year, you would put $85,500 in tax-deferred accounts and $5,500 into tax-free accounts. That’s close to 10% of your stock option cash of $1 million moving out of taxable accounts and into other, more tax-efficient accounts that provide you with huge tax savings.
Now, let’s say you decide to change jobs in a few years. When you do, you can do a split rollover (see IRS notice 2014-54 for more details on how this works).
That will help move all your after-tax contributions into a Roth IRA — which means $35,500 per year, multiplied by the number of years contributions were made, equals the amount of money you can move into a tax-free investment account.
If you contributed for five years, that means you could move $177,500 of the $1 million cash you had into a tax-free account.
Or maybe you want to take some extended time off. If you do so, your tax bracket will drop, and that provides a great opportunity to start executing Roth conversions to move money from a tax deferred account into a tax free account. You coordinate this with your time off so that the conversion is taxed at a lower rate.
If You’re Not Already, Start Considering Dollar Location as Part of Your Stock Option Investment Strategy
Dollar location is the most powerful stock option investment strategy available to you. Unfortunately, it’s also the least used.
But now you know how important this is, and you can save an enormous amount of the taxes you have to pay over your lifetime if you only consider what accounts you allocate your cash to.
Don’t pay more in taxes than you should. Work with a professional to ensure you’re making the most tax-efficient moves possible — not just for today, but for your wealth years down the road, too.