Recently, in A Tech Employee’s Guide to RSUs, we covered the following key points regarding RSUs:
- They are a popular form of stock compensation, which are taxed as income as they vest.
- Shares held after vesting are taxed as capital gains when they are sold.
- It’s important to periodically manage your company stock to prevent concentration risk and income/career risk.
- If you are an executive or insider, take care to follow company and SEC guidelines when buying/selling company stock.
If you are looking for a summary of how RSUs work, I recommend starting with that post.
In this article, we’ll dive deeper into four planning opportunities (covering tax mitigation and hedging strategies) for employees looking to optimize their financial planning strategy for this type of compensation.
1. Using RSUs to MAXIMIZE Tax Deferred Contributions
Contributing to your employer-sponsored 401(k) account or an individual retirement account (IRA) comes with a tax benefit, as a contribution to these accounts reduces your taxable income in the current year. But an additional planning opportunity exists for anyone who is holding vested RSUs but not maxing out these accounts due to cash flow constraints.
If you are holding RSUs to delay paying taxes on the gains, the proceeds from the sale can be used to fund tax-deferred accounts and offset your tax bill (in addition to diversifying your investment portfolio).
Let’s look at an example.
Marcia has 2,000 vested RSUs worth $10/share and a cost basis of $5/share. She has held the shares for more than two years and is contributing $10k of the allowable $19,500 in her employer 401(k) plans. She is not contributing to an IRA account.
Additionally, her income places her in the 15% and 24% tax brackets for capital gains and income, respectively.
In this scenario, Marcia could sell her 2,000 shares for $20k, creating a capital gains tax liability of $1,500 ($5 gain x 2,000 shares x 15% tax rate). Then she could use the first $9,500 of the proceeds to max out her 401(k) account—netting a tax reduction of $2,280 ($9,500 x 24%). With the remaining money, she could contribute up to $6k to a traditional IRA account and reduce her tax bill by up to another $1,440 ($6,000 x 24%)—subject to phaseouts based on income.
Here’s what this looks like:
All in, this strategy could save Marcia up to $2,220 ($3,720 saved – $1,500 in capital gains tax) in taxes in the current year while allowing her to diversify her investment portfolio and save money in a tax-advantaged account.
Now, for those of you already maxing out your retirement accounts, the next strategy might be for you.
2. Deduction Bunching
With the increase of the standard deduction to $24,800 for couples and $12,400 for individuals as part of the 2017 Tax Cuts and Jobs Act, deduction bunching becomes that much more important for anyone looking to itemize deductions as part of their tax returns.
Essentially, deduction bunching is squeezing as many deductions as possible into one tax year in order to boost itemized deductions above the standard amount and therefore minimize taxes in that year.
Because RSUs are taxed as income in the year they vest, if you have a large tranche of RSUs vesting in any given year, you should consider bunching deductions to offset some of this income.
The most common itemized deductions are:
- Mortgage Interest
- Charitable donations
- Medical expenses
- And State and Local taxes (known as SALT deductions) including real estate taxes
Because SALT deductions are now capped at $10k and mortgage interest doesn’t lend itself to bunching, the opportunities here are with mainly with charitable donations and possibly with medical expenses.
Medical expense deductions, starting in 2020, are limited to the “total qualified unreimbursed medical care expenses that exceed 10% of your adjusted gross income.” If you have a year with high medical expenses pushing you over the 10% threshold, the opportunity exists to prepay any upcoming costs and to pull as much of the deduction into the current year as possible.
For example, if your kid is due for braces, your orthodontist may allow for payments to be spread out over a couple of years. But, if you are over the 10% AGI threshold and can swing it from a cash flow perspective, you should consider paying the full cost upfront in order to bunch the expenses and pull the tax benefit into the current year.
Charitable giving is the same. If you are charitable, and can afford to, in a high-income year driven by RSUs, you can pull five years of giving forward into the current year in order to bunch deductions and further reduce your tax bill. (In the next section, we will look at a popular vehicle to make this process easier.)
A side-by-side comparison of how this would look is below. In this scenario, we compare the standard deduction (without bunching) to itemized deductions with bunching. We assume an extra $2k in medical expenses, which are deductible and bunching five years of charitable contributions at $5k per year.
The bunching strategy results in an additional tax deduction of $20,200 in the current year with no reduction in subsequent years (since you will use the Standard Deduction) and saves you nearly $4,500 on your tax bill today.
3. Donor Advised Funds
Let’s say you have the ability to pull five years of charitable giving forward, as in our example above. But, like many people, you would still prefer to give the funds over the five years while getting the tax deduction. How can you achieve this? Enter the donor-advised fund (DAF).
We’ve written before about utilizing a DAF, but quickly recapping the key steps:
- Open a Charitable fund in your name
- Contributions to the fund are deductible in the year received
- Assets can be invested and grow tax-free
- Grants can be made to charities at any time in the future
What’s more, highly appreciated securities can be used to fund a DAF—not only scoring a tax deduction in the funding year but also avoiding capital gains tax on the donated securities.
Essentially, utilizing a DAF allows the charitable bunching strategy combined with the capability to give as you typically would. The only downside is that you must have the ability to fund the account upfront, and the donation is irreversible. Once you’ve funded a DAF, the money must be given to charity.
4. Hedging With Options
While our first three strategies covered reducing your tax bill today, our last planning strategy explores a way to hedge your RSU position and delay the sale—either because you need to maintain a position in your company stock or to delay the tax bill to a potentially more favorable year.
A quick caveat—options can be risky and should be fully understood before implementing any strategy. Additionally, like with anything, there is no free lunch. Hedging a position, even if generating income in the process, comes with tradeoffs.
Let’s look at a couple of the most common strategies: The covered call and the collar.
Under this strategy, call options are sold above the current price (called out of the money). This generates income but caps your potential for gain with essentially all the risk of loss remaining.
In the scenario below, using Intel’s stock from February of 2020, we depict this strategy of selling $70 calls that expire in January 2021. This brings in a premium of ~7% but caps your maximum gain on the position at 13%—at a price of $70 per share or higher. However, as you can see, the downside is essentially uncapped save for the 7% premium generated.
The tradeoff for generating this premium income is capping your return at 13% and still taking the downside of the stock. However, if the stock price doesn’t move over the next year, you have generated a nice healthy income stream over the period.
Unlike the covered call strategy, a collar strategy does hedge the downside by buying a put. However, instead of just buying a put (which is expensive), a call is also sold to offset some or all of the costs.
In our example below, selling January 2021 calls and buying puts on Intel stock leads to a premium income of 1.4%. The tradeoff is minimal income and a narrow range of potential outcomes.
Either of these strategies could be right for your given situation, but the point is they aren’t without risks and tradeoffs. However, they could help you defer the sale of your RSUs until a more favorable time.
So that’s it—which strategy will you use to make the most of your RSUs?
As always, if we can be of any help or if you would like to discuss the optimization strategies herein, you can get in touch here. As we mentioned above, options can be risky and should be fully understood before implementing any strategy. Additionally, like with anything, there is no free lunch. Hedging a position, even if generating income in the process, comes with tradeoffs.