This past weekend, I had the joy of watching the movie The Sandlot with my 7-year old daughter and 4-year old son. My joy came from my kids laughing at all the moments in the movie that I laughed at the first time I saw it 25 years ago. They particularly enjoyed this scene and learning what a “pickle” is in baseball (for those who aren’t familiar with a pickle in baseball, here are some good examples). If you haven’t seen The Sandlot, the predicament (or “the pickle” as to which it is referred) the characters in the movie find themselves in is that they accidentally hit a baseball signed by the great Babe Ruth into a yard that has a legendarily vicious dog prowling about. So, the pickle is: do the kids give up a ball signed by one of the greatest players in history? Or, do they risk severe canine retribution for trespassing and try to get the ball back? Tough decision. I’ll let you watch the movie to see how it played out, but just like investment decisions, a great deal of effort goes into attempting to minimize risk.
In Part 1 of this post we discussed how it is not uncommon for a long-time employee of a corporation to find themselves in a different kind of pickle. The predicament in this case being: do you sell your company stock and pay a potentially large amount of money in taxes? Or, do you keep the company stock and subject yourself to the risks that come with concentrating your assets in one company’s stock?
Fortunately, the latter predicament has more options than the kids in The Sandlot had, and last time, we discussed how the first option selling all the stock now and paying the tax might very well be the best option. Remember: a huge tax bill could very well be worth the benefit of diversifying a risk—especially if that risk could mean having to work 5 more years. If, on the other hand, we determine that the risk of waiting to sell is palatable, or the tax benefits too great to ignore, then it’s worth considering other options for diversifying the stock:
Option 2 –Time Stock Sales to Limit Taxes
The longer one holds an individual stock, the longer they are subjected to the risks, but that time holding the stock could bring tax benefits with it. It may be worthwhile to consider timing the sales. In the case where one has a large holding of company stock, it is likely they have held the majority of the company stock for over a year and the gains will be taxed at favorable long-term capital gains rates. It may, therefore, seem like there wouldn’t be much benefit to selling in this year, next year, or in 5 years aside from tax deferral if they are ultimately paying long-term capital gains rates. However, there could be a huge tax benefit to timing the sales because that additional income will affect one’s total taxable income which is used to determine income tax rates.
Take, for example, a married couple. Both spouses work and together, with bonus and salary, they have a taxable income of $300,000 after deductions. Under current tax law, this couple is in the 24% marginal tax bracket. If, however, their taxable income increased above $321,450, they would jump to the 32% marginal tax bracket (you can see federal tax rates here). Keep in mind, capital gains are counted in totaling taxable income. While long-term gains are taxed at favorable rates, gains will be counted in taxable income totals which determine the rate at which the rest of your income is taxed.
So, if that couple had an additional $100k in gains from selling company stock, they will now have a taxable income of $400,000. Due to the gains generating from selling company stock, $78,550 of earned income ($400,000-$321,450) will be taxed at 32% instead of 24%. That’s $6,284 (8% of $78,550) of additional taxes owed on earned income that is in addition to the taxes they will pay on the capital gains.
But, if the married couple above is comfortable with the risk of waiting to sell stock to save on taxes they could consider these two options:
(a) – Sell in a lower taxable income year
It could be the case that a lower taxable income year is very near on the horizon. Using the example above, let’s say the husband plans to retire in 2020, and as a result, he won’t have income in 2021 and the couple’s taxable income will drop to $180,000 in 2021. Now, selling company stock and generating $100,000 in capital gains will have a very minimal impact on how their income is taxed because, regardless of the gains, they will remain in the 24% marginal income tax bracket. While it’s true that more of their income will be taxed in the 24% marginal tax as a result of selling the stock there isn’t nearly the jump in costs that we saw between the 24% and 32% brackets as illustrated above.
(b) – Sell enough each year to fill their marginal tax bracket
Using the above example, the couple could sell as much stock as they could but only up to point of generating $21,450 in gains—the maximum amount they could generate without pushing into the 32% marginal tax bracket. They could then repeat this each year until all the stock is sold. Further, they could do this by selling the company stock certificates that have the highest cost basis first (the holdings with the smallest gains), so that they could diversify more stock up front and further minimize risk.
Bottom line, when it comes to taxes (and so many things in life) timing matters. If you deem the risk of waiting is palatable, there could be a tax benefit. Now, let’s look at one more option because it may be that the tax benefit of waiting is a big one, and the risk is such that one is willing to consider other means of limiting risk.
Option 3 – Time the sale but hedge for now.
In this example, imagine the couple from Example 1 has $400,000 of taxable income in ’19 and they will be well into the 32% marginal tax bracket. However, they both plan to retire at the end of the year and they anticipate having $0 earned income in 2020 (they are both 63 and don’t plan to draw Social Security until 70). Further let’s imagine they have $750,000 in company stock that has $250,000 in capital gains. They would love to wait to until 2020 to sell the stock since they will have $0 in other income, but they also know that the value in that stock is what will allow them to stay retired. They can’t risk it dropping by even 15% from its current price of $40/share.
This couple might consider these two hedge strategies:
Hedge 1 – Buy Put Options
Buying a put is when you purchase the right to sell someone your stock at a set price until a certain date.
In this example, the company stock the couple owns is priced at $40 today. If they are concerned that their retirement is in jeopardy if the price drops below $35 between now and January 1st of 2020, they could buy the right to sell the stock at $35 until January 1st of 2020. This is called buying a put. In this example let’s say that the put option costs $1/share for easy numbers.
If the stock drops below $35 they’re max loss is the $5/share they lost plus the $1/share cost of the puts they purchased even if the stock goes to $0.
If the stock goes up, they benefit from the value increase minus what they paid for the put options.
Buying puts can be expensive, but in an example like this it could be well worth the downside insurance provided while still allowing the couple to enjoy potential upside.
Hedge 2 – Buy Puts and Sell Covered Calls (also known as a “collar”)
In this strategy, to offset the price of the put, the couple could sell covered call options in addition to buying puts. Buying a put and selling a covered call on the same stock is called a “collar” because it limits the outcomes on the upside and the downside.
Selling a covered call is when you sell someone else the right to purchase stock that you own for a set price until a specified date.
Returning to the example, the stock is worth $40 today. The couple could sell someone else the right to purchase the stock for $45/share before Jan 1st of 2020. If their stock went up to $50, the purchaser of the call could exercise their option and purchase the stock from the couple for $45. The couple would miss out on that additional $5/share of upside resulting from the stock rising above $45 but selling these covered calls would have compensated them for the puts they purchased.
Here, the couple has given up the benefit to the stock rising above $45 but eliminated the downside risk of the stock falling below $35. While they won’t benefit from much potential upside, they have hedged the risk and can safely hold the shares until they can sell them in the more favorable tax environment that awaits them in 2020.
Keep the Objective in Mind
There are even more options than what I’ve written about here, and more nuance to those that I’ve described, but in determining what to do with company stock the most important thing is to keep your ultimate objective in mind.
In most cases, if you have company stock, the stock’s value is a means to an end. Likewise, the money you save in taxes can be used as a means to the same end. The end could be retirement, a child’s wedding, a charitable donation, etc. Whatever the desired objective may be, when you make a decision about selling company stock, do so with the objective top of mind. This will help you evaluate the true risks of waiting and the benefits of potential tax savings. It’s easy for one to say that they are comfortable with a 20% decline in the value of an asset, but it’s much more difficult to be comfortable with a similar decline in the likelihood one can achieve a specific objective (e.g., a 20% likelihood I won’t be able to retire when planned). Keeping the objective in mind will help clarify the best option and make it feel like less of a pickle.