Today I’m clearing up some confusion from a prior episode.
I’m also tackling part 2 of our equity compensation series.
Specifically, I’m sharing the following key takeaways.
- How ESPP Lookback Periods Work
- Qualifying vs Disqualifying Dispositions
- Tips for Offsetting an RSU Tax Bill
If you want to better understand the tax implications of equity compensation, you’re going to love today’s episode.
How to Listen to Today’s Episode:
Episode Links & Resources:
- 👉 Get Your One-Time Retirement Plan
- GE Stock Split [Yahoo! Finance]
- Apple Stock Split History [Investopedia]
- Equity Comp Resources:
- Donor-Advised Funds:
I Made a Mistake + Equity Compensation Part 2
Taylor Schulte: Hey everyone. I made a mistake that I want to clear up before we start today's show. And maybe mistake is a strong word, but it's possible that I caused some confusion and the confusion actually brought to the surface an interesting topic.
In part one of this series, which aired two weeks ago, I shared a brief history of General Electric stock price and referenced it dropping to a low of $7 per share in 2018. Well, if you pulled up the GE stock ticker today, you would see that it's trading around $108 per share, which might lead you to conclude that the stock has made a nice comeback.
If you looked a little bit closer, you might have also noticed that in 2018, the stock traded at a low of around $53 per share, not the $7 per share that I referenced. Yes, I have three kids under age five, but no, I have not completely lost my mind yet. Here's what happened.
The last episode happened to be prepped for prior to July 30th of this year, and July 30th is important because that's when GE did a one-for-eight reverse stock split. The pre-split price was $12 and 69 cents, and the post split price traded just over $101. That's eight times $12 and 69 cents. That's the one for eight reverse stock split.
A stock split like this doesn't change anything about the company's financial condition and doesn't change the dollar value of any GE stock and investor owned through the split. You as a GE investor essentially have fewer shares that are now trading at a higher price. Every eight shares you owned were automatically combined into one share. And this reminded me of a conversation I had a couple of weeks ago with friend, client, and an avid listener of the show, Dan M in Northern California.
Hey, Dan, hope you're doing well. Dan and I were chatting about individual stocks, specifically Berkshire Hathaway, and the price per share came up in the conversation, to which I quickly shared that the price per share of a stock is mostly optics.
In some cases, like Apple stock for instance, a lower price per share can make it more attractive to investors who either can't afford to buy shares at higher prices, or wrongly believe that stocks trading at a lower price means they have more upside potential, which is why Apple did a four to one stock split in August of 2020. The fifth stock split since it went public. The 2020 stock split took the stock from trading around $500 per share last year to about $125 per share. Nothing changed about Apple or their financial condition or their future growth plans. Investors just ended up with four times more shares that are now trading at a quarter of the price.
And fun fact, if Apple never did a stock split, remember they did five of 'em since they went public. If Apple never split at stock, a single share of Apple today would be worth about $28,000. So Apple's stocks split in history is one example that's relatively common, but there are other situations like General Electric where a low price per share could potentially lead to negative outlooks about the stock, a one-for-eight reverse split the opposite of what Apple did, hopefully, helped to improve the outlook of the stock and maybe lead to investors looking past some of their le their recent struggles.
A low of $53 per share in 2018 certainly looks better than a low of $7 per share. When looking at the chart history of GE stock, again, it's mostly optics. And one final note, a high price per share preventing some investors from owning a stock is actually becoming more and more irrelevant given the rise of fractional trading.
In other words, it doesn't really matter if Tesla is trading at a thousand dollars per share and you don't have a thousand dollars to invest, you can buy one 10th of a share for a hundred dollars, let's say, through most custodians offering fractional trading. It doesn't change how the price per share might influence an investor's perception of the company, but it does make investing in individual stocks more accessible.
And I'm not saying that investing in individual stocks is a good thing, by the way. However, I do think that making investing more accessible is a step in the right direction. So with that out of the way, let's get onto today's show.
Welcome to the Stay Wealthy Podcast. I'm your host Taylor Schulte, and today I'm tackling part two of our equity compensation series. Last week we covered the basics of RSUs and apps, two of the most popular forms of equity compensation. And this week I'm getting a little bit into the weeds and sharing how ES PPP lookback periods work, qualifying versus disqualifying dispositions of ES PPP shares, and then tips for offsetting your RSU tax bill.
So if you wanna better understand the tax implications of equity compensation, you're gonna love today's episode. For the links and resources mentioned, head over to youstaywealthy.com/133.
Let's do a quick recap before we dive further down the equity comp rabbit hole. Equity compensation is a non-cash benefit offered to employees. While getting a cash bonus from your employer can be a nice benefit, equity comp benefits allow employees to share in the profits and upside of the company, which in some cases can prove to be even more rewarding than cash in your pocket over long periods of time. And the two most popular types of equity compensation programs are employee stock purchase plans.
A KPPs and restricted stock units or RSUs PPPs allow you to buy your company stock with your own money at a discount. Typically up to 15% you're taxed when you sell the stock. And how you are taxed depends on a few things which I'm gonna touch on shortly. RSU, on the other hand, are shares of stock given to you as the employee through a vesting plan and a distribution schedule.
You’re taxed at ordinary income tax rates on the vesting date, a date that you don't really have control over, you're also taxed on any capital gains if you choose to hold the stock beyond the vesting date and sell it at a price that's above the vesting price. This is something that you have control over. You don't have to hold onto the stock, you can immediately sell it when it vests.
Now, before we go into the nuances of ESPP taxation, let's first talk about ESPP look back periods. This is something that we did not cover in part one. I wanna make sure that everybody's caught up here. From there, I'll bring us home by outlining some tips for offsetting a tax bill caused by vested RSUs. So as previously noted in an ESPP program, you have to elect to defer a percentage of your salary into the plan.
In other words, you can't just buy your company stock through an ESPP with cash from your checking account. Let's say, you also can't defer and contribute just any amount that you want. The IRS has limits and the limit in 2021 is $25,000.
By the way, I should note here that elected ESPP contributions are based on your gross salary, i.e. your salary before any taxes are taken out. For example, if your gross salary is a hundred thousand dollars and you elect to contribute 10% into your ESPP program, you will be electing to purchase $10,000 of company stock that year. So just keep that in mind when deciding how much company stock you want to purchase in a given year as it could cause you to buy more stock than you intended and or cause some cash flow issues if not properly planned for.
So to participate in your ESPP, you elect to defer how much you want to contribute per pay period up to that $25,000 annual limit during what's called the enrollment period. The enrollment period is typically every six months, and at the end of the six months, the money you elected to defer into the ESPP is used to purchase company shares at a discount, usually up to 15%.
Here's where it gets a little bit more interesting, especially since we're dealing with individual stocks here. In some cases, the discount is applied using what's known as a look back period for those lucky enough to have a look back period, ESPP shares are either purchased based on the price of the stock at the beginning of the enrollment period or at the end of the period, whichever is lower. It's a pretty sweet deal, right?
It's a win-win for you, the investor, because if your company stock goes to goes from $20 to $40 during that six-month enrollment period, well, you get to buy your discounted shares at the $20 per share price. On the other hand, if the stock goes from $40 to $20, the way it goes down, the look back period becomes irrelevant and you just simply buy your discounted shares at the current price and you walk away pretty happy that you didn't get stuck buying on the enrollment period start date at $40 per share knowing that individual stocks can be volatile in either direction.
This is a really highly valued benefit for ESPP participants. With a better understanding now of the ESPP purchasing process, let's now move into some of the important nuances I referenced earlier when it comes to the taxation of the company stock you elect to purchase because it works a little differently than what we're used to when investing in a personal brokerage account.
As previously mentioned, you don't pay any taxes on shares acquired through your ESPP until you actually sell them. However, when you do sell them, how you are taxed depends on which type of disposition this sale results in. And thankfully, there are only two types of dispositions qualifying and disqualifying.
A qualifying disposition is when shares of stock that you purchased through your ESPP are held for two years from the enrollment period start date, and one year from the purchase date. Remember, the purchase date is six months after the enrollment period start date also commonly referred to as the grant date.
A disqualifying disposition is pretty simple. It just doesn't meet the qualifying criteria that I just referenced. Shares are not held for two years from the grant or enrollment date and not held for one year from the purchase date.
If shares are sold under a disqualifying disposition, the difference between this sale price and your discounted purchase price is taxed 100% as ordinary income or earned income. It's also subject to any applicable state and local taxes as well.
So for example, if you bought your company stock that was trading at $20 a share for $17 per share due to your 15% discount, and then you immediately sold it at its current price of $20, that $3 per share owned would be taxed at your ordinary income tax rate. It's really not all that different from short-term capital gains rules where your tax at ordinary income tax rates when you sell an investment at a gain that you've held for less than one year.
Here's where it gets a little bit more interesting, though. If shares are sold under a qualifying disposition, only the discounted amount is treated as ordinary income while the remaining gain, if there is any, is tax at the often more attractive capital gains tax rates.
Going back to the previous example, if you bought your company stock that was trading at $20 for $17 due to your 15% discount, and the stock went up to $40 while you waited the appropriate amount of time that you needed to, to sell it as a qualifying disposition, you would pay ordinary income on that $3 per share, right? That discount, that difference between $20 and $17, you'll pay ordinary income on that $3 per share.
But on the gains, the additional $20 where the stock went from 20 to 40, the remaining $20 per share will be taxed at more favorable capital gains tax rates. While the tax benefits of a qualifying disposition are very clearly more favorable. There's one big issue with this approach that you might've already picked up on, which leads most financial planners, including myself to recommend selling E S P P shares immediately under a disqualifying disposition and going ahead and paying those ordinary income taxes on the gains.
Here's why. In order to get the more preferential tax treatment of a qualifying disposition, you have to wait a year and a half from the purchase date. And as we all know from the last episode, anything can happen to an individual stock in an 18-month time period. So unless you're intentionally trying to buy and hold shares of company stock for long periods of time, it usually makes sense to sell them immediately and lock in the free money from your employer.
Would the free money being the discount of up to 15% that you're getting on that stock purchase? Because if an employee decides to wait the appropriate amount of time to qualify for that qualifying disposition and the price of the stock goes down below the discounted purchase price, this whole song and dance of deferring money from their paycheck to to buy stock at a discount through their ESPP, this whole thing was a complete waste of time that that money likely could have been put to better use somewhere else, but instead, they were gambling on the short term performance of one single company as we hit on pretty good.
And in the last episode, the typical recommendation is to buy the stock at a discount through your ESPP, sell it immediately. Pay the ordinary income taxes, lock in the free money that your employer is giving you, and then reinvest the proceeds into a diversified portfolio or fill up your emergency fund or set that money aside for an estimated tax bill or even save it for your next home or vacation.
Now, if you believe in the long-term potential of your share of the stock of your company, which many of our clients do, just consider those shares as part of your cowboy or cowgirl account. My rule of thumb is, as you guys all know, is to limit your cowboy or cowgirl account to 5% of your total investible assets. But a case can be made to maybe go as high as 10% if it includes company stock that you have a better understanding of versus a penny stock that your neighbor told you about.
If the retirees at General Electric that put in 40 hard years of work had taken that approach, they may have been able to hang it up and enjoy retirement instead of looking for another job in their sixties and seventies. By the way, I realize that I'm picking on one single company here, and that there are hundreds, but probably thousands or tens of thousands of success stories where taking my approach would've meant watching a lot of people.
You make millions of dollars while you're stuck in boring, diversified index funds. as, as I'm always quick to highlight here, there's no such thing as a free lunch. If you take more risk, you should expect a higher rate of return. You should also expect catastrophic events to be even more catastrophic and sometimes irrecoverable. So if you want to hold onto larger percentages of company stock for long periods of time, that's okay.
Just acknowledge that you're taking on more risk. You should document it, tell your spouse, and be sure to just plan accordingly. It's better to be prepared for these worst-case scenarios than to fool yourself into thinking that a General Electric type of event will never happen to you or your company and your retirement savings.
Before we move on to RSUs and how you can offset a tax bill from vested shares, a quick note that I'm linking to a free ESPP tax calculator and tax return estimate tool in the show notes, which again can be found by going to youstaywealthy.com/133.
And I found this calculator through a friend of mine and a fellow planner, Isaac Presley, who's up in the Pacific Northwest. he's written a number of great articles on equity compensation, which I will also link to in the show notes.
Okay, let's wrap things up with RSUs. As mentioned, the taxation of RSUs is pretty straightforward, your tax as earned income when the shares vest, which is not all that different than an employer giving you a nice cash bonus and like a cash bonus. Sometimes the amount of money vested from these RSU can be much higher than you expected, meaning you can have a much larger tax bill that you maybe didn't plan for.
In these situations, clients often ask us, what can I do to help offset this giant unexpected tax bill? And there are two common strategies to consider if and when you are in this situation. The first is an easy one, which is to use the vested RSU proceeds to make sure you're maxing out all tax deductible retirement accounts. This could be your 401k, a traditional ira, or even an hsa.
While you might have not had the cash flow to max out all these buckets prior to the vested RSUs, well now you do. Now you can consider using some of these proceeds or all of the proceeds from selling your shares to accomplish this. And since the vested RSUs are a taxable event, making deductible contributions to a retirement or HSA will of course knock down your taxable income and help to offset your tax bill that year.
Now, many of you might already be maxing out all of your tax-deductible buckets. You might also have vested RSUs that are causing much bigger tax issues, where a $26,000 401K contribution doesn't really put a dent in anything. In that case, charitable giving is likely going to make the biggest dent in mitigating your tax bill when income spikes due to vested RSUs.
I do realize that not everyone is charitably inclined and that giving money away to save on taxes seems a little contradictory or backwards as shared before on the podcast, you should never give to charity for the tax break. But if you do have any sort of charitable intent now or even in the future, being strategic about when and how you donate money can make a giant impact on your lifetime tax bill.
The most flexible way to go about charitable giving during a high income year, like a year where these RSU just fell in your lap, is to utilize a donor-advised fund, also referred to as a DAF. I've covered these at length before, so I'm not gonna go into the details here today. But in short, the great thing about a DAF is that you can get the tax deduction today when you fund the account and then take your time donating the money to charities to the charities of your choice.
In fact, you can even put a letter on file that says, you know, when I pass away, please donate the money in my donor advised fund to this charity or these 10 charities or 20 charities, whatever it is.
So if you don't know who you want to give money to today, but you know you want to give money away at some point in your life, this can be a good solution. Another application is for people who plan to give money away at death. For example, perhaps your living trust has some language stating that at your death you would like x percent of your estate to be donated to some charity.
That's a really nice gesture, but you're not gonna be able to utilize the tax deduction for your very generous gift in this scenario where you're not alive anymore. So perhaps you fund a donor advised fund account today during a high income tax year where you can really use the tax benefit and then put a letter on file instructing the donor advised fund custodian where to send your money at death.
And now you've fulfilled your end of life charitable giving goals and also benefited from a healthy tax deduction when you really needed it. To build on that a little bit further, you can also choose to invest the money inside your donor-advised fund account, which can open up a couple of other considerations.
For example, let's say your living trust states that you want to donate a hundred thousand dollars from your estate to the charity of your choice when you pass away. Well, depending on your life expectancy and projected investment returns, you could potentially fund a donor advised fund account today with, let's say, $50,000. That's half the amount you had planned to give away at the end of your life. Invest that $50,000 inside the donor advised fund in stocks and bonds and grow that account to maybe a hundred thousand dollars at death.
You could also choose to take a more generous approach here and contribute the full $100,000 today to your donor advised fund account since that's what you intended to do anyways, at the end of your life, invest that a hundred thousand dollars and maybe be able to give away $200,000 or more to the nonprofit or, or nonprofits of your choice at death.
If you plan to give away money at your death, those charities would love for you to be investing that money today while you're alive so that they can potentially receive an even larger donation in the future. There are a number of different ways where you can utilize a donor advised fund and other charitable giving types of accounts to help reduce your tax bill while also fulfilling near term and long-term charitable goals.
If you wanna learn more, I will provide a few links in the show notes about these really great charitable giving accounts and how you can use them in your retirement planning. To access the show notes and all the links and resources mentioned today, head over to youstaywealthy.com/133.
Thank you as always for listening, and I'll see you back here next week.
Episode Disclaimer: This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services.