Strategic tax planning is a must-do for tech pros.
Carefully weighing the tax implications of your financial decisions can help keep more of your money working for you and ultimately reduce your overall tax liability. While paying taxes will always be part of the deal, you should walk in with both eyes wide open.
Many people associate tax time with early spring, but there are plenty of opportunities to consider before year-end. Let’s take a look at a few critical tax planning avenues for your 2021 return.
Plan for Vested Equity
First, take stock of your equity compensation—or compensation in the form of equity as we like to call it.
Reframing your equity, like RSUs and stock options, as compensation first offers a fresh perspective on their corresponding taxes.
You expect your income, aka compensation, to be taxed—just take a look at any of your paychecks. The same is true for equity, but you can be cognizant and strategic with your tax decisions.
Before year-end, evaluate how much compensation you can expect from your equity. When your RSUs vest, the IRS considers the value to be W2 income—immediately. Think about vested RSUs like a cash bonus, something the IRS doesn’t think twice about taxing.
Assume 1,000 shares vest, and the stock’s current value is $20. In this case, you added $20,000 to your W2 income. Keep in mind that you’re taxed on the value of your vested RSUs no matter if you hold or sell them.
While it’s generally beneficial to sell all of your RSUs when they vest, at least consider selling enough to cover the tax liability. Your employer will withhold at a 22% statutory rate, but your true tax liability will be based on your marginal tax rate. If you expect to be in a 35% marginal bracket for the tax year, you should set aside an additional 13% x the gross value of the vested RSU’s.
Investing in your Employee Stock Purchase Plan (ESPP)? The company stock that you bought at a discount is taxed at ordinary income rates.
Even if you meet the requirements for a qualified disposition (hold stock at least 2 years from the start of the offering period and 1 year from the purchase date), you still accumulate W2 income on the discounted stock price. From a tax perspective, it’s like your employer gave you the discount in cash.
With a qualified disposition, any remaining gain is taxed at long-term capital gain rates.
Unlike RSUs and ESPPs, vested ISOs don’t trigger a taxable event. The tax liability comes later when you sell. But before you sell shares, you have to exercise (or purchase) them. Consider the following questions.
- Do you have options vesting soon?
- How much (if any) should you exercise this year?
- Are any of your shares set to expire?
- Do you have the cash flow to purchase the shares?
- Would you plan to hold or sell the stock?
Remember that exercising and holding your ISOs beyond 12/31 of that calendar year will count toward your alternative minimum tax (AMT) calculation. Unlike the regular tax calculation which recognizes the ISO income (FMV minus strike price) when you actually sell the stock, the AMT calculation recognizes the ISO income when you exercise and hold beyond the end of the current calendar year. If you plan on exercising and holding a large number of shares, it is best to have a tax professional calculate your AMT bill so you aren’t caught by surprise when you file your tax return in April.
Keep Your Investment Practices Tax-Efficient
Sometimes it may be challenging to remember that there is an expansive investing world outside of your “compensation in the form of equity.” Still, there is, and it’s just as important to approach it from a tax-efficient lens.
One way to ensure your investments have a fundamental tax-efficient structure is to consider asset location. Asset location is a strategy that seeks to house particular securities (stocks, bonds, ETFs, REITs, etc.) in the most tax-efficient accounts (taxable, tax-deferred, tax-exempt). The ultimate goal with asset location is to minimize lifetime taxes and maximize after-tax returns.
Asset location begins to answer questions like:
- Should you keep municipal bonds in a traditional IRA?
- Which investments thrive in a Roth IRA or Roth 401(k)?
- Where’s the optimal spot for your real estate investment trust?
- Which account tends to offer the best long-term tax impacts on growth and value stocks?
Building an appropriate asset location strategy for you considers various factors, including your asset allocation (the securities you invest in), each asset’s tax characteristics, investment accounts, and your unique long-term goals.
With investing, losses can be just as significant as gains. But there is a tax-friendly way to approach your losses via tax-loss harvesting.
Tax-loss harvesting is a strategy where investors can sell an asset at a loss to help offset a capital gain. Additionally, you can use this strategy to offset up to $3,000 in ordinary income ($1,500 if married filing separately). Should you lose more than the limit, you can carry the loss forward to a future year.
Mind the wash-sale rule! If you sell an asset at a loss and buy back a “substantially similar” one within 30, the IRS considers it a wash, and the loss is no longer deductible.
But tax efficiency only gets you so far—it isn’t the end-all-be-all of your portfolio. While it’s prudent to make tax-conscious and friendly decisions, taxes shouldn’t solely dictate your investment practices.
Taxes are one piece of the puzzle, but several others like your risk tolerance and capacity, time horizon, and investment goals all have to work together to create a strategy that’s right for you.
The bottom line: the tax tail should not wag the investment strategy dog.
Maximize Donation and Giving Strategies
Giving can be an essential part of people's financial plans. While it's convenient and straightforward to give with cash or a check, several other more lucrative options are available.
- Donate appreciated stock. Giving stock is an excellent alternative to cash because both you and the charity forego the capital gains, maximizing your gift and managing your tax situation.
- Add assets to a donor-advised fund (DAF). Think about a DAF as a charitable investment account. You can donate anything from appreciated assets to collectibles to property. You may even be eligible for an immediate tax deduction upon contributing. Once the assets are in the account, you make recommendations over time to donate the funds to a qualifying charitable organization.
- Use a bunching strategy. The Tax Cuts and Jobs Act skyrocketed the standard deduction, making it more challenging for families to take advantage of itemizing deductions. For 2021, the standard deduction is $25,100 for joint filers and $12,550 for single filers. If you’d like to itemize, consider bunching charitable donations. Say you and your partner aim to donate about $15,000 per year. Doing so doesn’t surpass the standard deduction. But, if you donated $30,000 every two years, you’d have the opportunity to itemize while still maintaining your ideal giving number. In years with no donations, you’d simply use the standard deduction.
The primary goal with charitable donations is supporting a cause or organization you care about, and getting a tax break along the way is just a bonus.
Invest In Real Estate? Two Strategies to Minimize Capital Gains
Real estate investing is certainly a hot commodity, but making money from real estate investments isn’t all that simple, and the tax liabilities can be even more convoluted.
But if real estate investing fits into your long-term plan, there may be a couple of strategies to help assuage capital gains: qualified opportunity funds and 1031 exchanges.
Qualified Opportunity Funds (QOF)
The Tax Cuts and Jobs Act introduced qualified opportunity zones, an investment avenue to inject capital into struggling areas in the U.S. Investors can bring much-needed economic relief to specific areas while receiving tax benefits along the way.
Essentially, this opportunity allows you to defer taxes on capital gains until 2026 by investing them in a (QOF) within 180 days of the sale. The capital gain can be on any asset like appreciated stock, for example.
QOFs are complex vehicles with some sophisticated tax rules. Here are a few things you should know.
- After investing in a QOF, taxable gains aren’t realized until December 31, 2026.
- QOFs are designed to be long-term investments, so you can receive a 10% step-up in tax-basis after five years. You are eligible for this benefit should you invest before the end of 2021.
- If you remain invested for 10 years, you won’t have to pay tax on the property’s appreciation. Essentially, while your gains will become payable in 5 years, investment proceeds won’t be available until year 10.
While QOFs can be a ripe investment opportunity, with investing, there is no “free lunch.” High tax incentives also come with high investment risks.
If you invest in physical real estate properties, you may be familiar with the concept of “like-kind” properties or properties of the same nature or character. Don’t let the term fool you; you can swap many different properties like land for a commercial building.
Under Section 1031 of the U.S. Internal Revenue Code, you can swap one like-kind investment property for another, all while deferring capital gains.
With a 1031 exchange, you can sell an investment property and reinvest the gains into a “like-kind” property within a certain period. Your investment continues to grow tax-deferred until you sell at a later date, hopefully for a profit and favorable long-term capital gains tax treatment.
Along with deferring capital gains, 1031 exchanges could prove beneficial when managing depreciation. You can only use a 1031 exchange on investment and business property, so a primary residence doesn’t count.
Complexities and nuances riddle 1031 exchanges, so ensure you work with a professional.
Strike a Balance Between Your Present and Future Tax Bracket
Proper tax bracket management is a hallmark of a solid tax planning strategy. It’s all about understanding what your tax bracket is now and what you anticipate it to be in the future. Having a sense of these two elements will help inform where and how you invest.
If, for example, 2021 has been a lower-income year for you, you might consider a Roth conversion. While you’ll pay taxes on the conversion, it will be at a lower tax rate than you’re used to.
Many tech professionals earn more as they progress throughout their careers, which means that you could be in a higher tax bracket as you near retirement than you are in currently. If that’s the case, you’ll want to consider prioritizing after-tax accounts like a Roth 401(k) to maximize tax-free withdrawals.
You don’t want to forgo your tax-deferred investment options (traditional 401(k) or IRA); it’s all about striking the right balance.
Build a Tax Plan That’s Right For You
A comprehensive tax planning strategy requires a solid financial team. Your financial advisor and tax professional should work together to help you build a holistic plan that takes all of your needs into account.
Year-end tax planning is significant for tech pros, especially when equity compensation, real estate, and other complex investments are involved. You want to get all of your financial ducks in a row, so you aren’t surprised when April rolls around.
Ready to clean up your year-end financial to-do list? Let’s talk about it together.