C-suite executives: Six strategies to maximize the tax efficiency of your portfolio
By Kelly Pedersen, CFP®
For C-suite executives, the reward of multi-faceted compensation packages comes with potentially significant tax consequences.
To be sure, executive compensation packages have become increasingly nuanced and complex. Thankfully, there are a variety of strategies that can mitigate the tax hit that executive compensation can trigger.
With the historically advantageous income tax and capital gains tax rates we currently enjoy potentially on the chopping block in the not-too-distant future, there is no time like the present to put together a comprehensive plan. Through working with a qualified financial advisor, busy C-suite executives can take steps now to help ensure that their well-earned compensation isn’t needlessly eaten away by taxes that could be avoided.
Limited access to a 401(k) plan? Take advantage of a 409A plan.
Highly compensated individuals (HCE), as defined by IRS rules for 401(k) plans, may be limited as to how much they can contribute to a company 401(k) plan.
For those individuals, including many C-suite executives, another option to consider is a “spillover plan,” if your employer offers such a plan. Essentially, a spillover plan is a retirement savings vehicle that is similar to a 401(k) plan, but it allows highly compensated executives to invest additional savings beyond the $20,500 limit. Some employers will match these contributions as well.
It’s important to note that you must choose at the time of setting up a 409A plan how you want to receive distributions when you retire. Options may include a lump-sum payment or distributions over a period of years. Be sure to consult with your advisor, as how you receive distributions from a 409A plan could bump you into a new tax bracket.
Also, know that money invested in a 409A plan is not “set aside and vested” like a 401(k) plan, meaning if your company were to go bankrupt, you could lose the money you’ve invested.
Restricted Stock Awards – whether to take an 83(b) election
For executives who receive compensation in the form of Restricted Stock Awards (RSAs), they have the option to take what’s called an 83(b) election. By taking that election, the income tax due on the RSAs are paid when the RSAs are awarded, rather than when they vest. Taking the 83(b) election can make a lot of sense if an executive believes a stock will appreciate in value, or their ordinary income tax rate / bracket is likely to go up in the future.
The point here is that one has to actively choose to take the 83(b) election. Many organizations don’t provide guidance on this election option, so talk to your financial advisor to determine the likelihood that the stock will appreciate in value and whether it may be more beneficial to take the tax hit now. By doing so, once the RSAs vest, there will be no income tax due. Upon liquidation of the RSAs, the proceeds are subject to capital gains rates instead of ordinary income, which can mean a significantly lower tax bill.
Are you withholding enough to pay the taxes due on your RSUs?
Many executives with Restricted Stock Units (RSUs) mistakenly believe that a sufficient amount of income is being withheld on their W2s to pay the taxes they will owe as RSUs vest. That’s not necessarily the case. The reason being is a company doesn’t necessarily know the full scope of its executives’ overall income and tax situation. Therefore, the amount of taxes withheld may not be enough to pay the taxes owed once RSUs vest.
Talk to your advisor to ensure you are withholding enough throughout the year to pay the taxes that will be owed when your RSUs vest. Properly structured withholding can prevent the need for future stock sales (if liquidity is needed to pay the tax obligation), which could be forced at inopportune times.
Take advantage of tax-loss harvesting
Tax-loss harvesting is yet another strategy by which executives can lessen the tax consequences of the securities they own. Essentially, tax-loss harvesting is the selling of investments at a loss to offset tax due on the sale of other securities that have generated capital gains. When you sell assets that have incurred a loss, it’s important to redeploy those funds right back into the market to hopefully capture the market upswing.
Because of the significant amount of securities in many executive portfolios and the likelihood of capital gains through the year, it’s important to work with a qualified financial advisor to ensure an ongoing tax-loss harvesting strategy is in place.
Particularly during market downturns, it can be advantageous to harvest losses on depreciated assets, allowing for the potential of offsetting gains on other highly appreciated securities, including equity compensation/RSUs that have vested but have yet to be sold at a significant gain.
Plan ahead to “bunch” deductions during high-income years
If an executive anticipates that he or she is going to have RSUs vest or liquidate soon, or a particularly big bonus is likely to pay out, and overall income is going to increase significantly, that can signal an ideal time to plan for “bunching” tax deductions. In other words, as you expect a big income year, also plan for a big deduction year as a way to lessen the tax consequences. Working with your financial advisor and tax accountant, accelerate any planned deductible expenses (e.g. charitable gifts, major medical procedures) as a way to offset expected increases in income and lower your tax obligation. For those who are philanthropically minded, contributing a significant lump sum to a donor-advised fund in a single tax year can result in a sizeable up-front deduction, even though the contributions from the fund can still take place over several years.
Don’t liquidate – move employer stock from a 401(k) to a non-qualified account
When an executive leaves a job or retires and wants to move assets in a 401(k) plan into an IRA, for example, he or she must liquidate any concentrated stock positions. In doing so, those liquidated assets are then taxed at ordinary income tax rates upon withdrawal from the IRA. A better solution can be to take any actual securities (of the company the executive works for) that are held within a 401(k) plan and transfer them into a non-qualified investment account. By doing so, ordinary income rates will only be levied against the employer stock cost basis at the time of transfer. The increase in value above cost basis will be taxed at capital gains tax rates at the time of sale, which are currently significantly lower than most ordinary income tax rates.