Financial Insights

Last week marked the beginning of the final quarter for 2022, and while it saw its fair share of volatility throughout the week, stocks ended the week positive. The S&P 500 ended the week up 1.56%. The strongest performing sector among U.S. large caps was energy, which off the heels of a rally in oil prices ended the week 13.86% higher. While of lesser magnitude, additional leadership came from the industrials (2.87%), materials (2.15%), financial services (1.94%), communication services (1.70%), and technology (1.67%) sectors. Healthcare (1.33%) lagged the S&P 500 but still finished positive, while consumer staples (-0.36%), consumer discretionary (-2.63%), utilities (-2.63%), and real estate (-4.06%) all finished lower for the week. U.S. small cap stocks outgained their large cap counterparts, with the Russell 2000 index returning 2.27% to start the fourth quarter. Foreign stocks also outpaced large cap stocks in the U.S., as international developed stocks (MSCI ACWI ex US index) and emerging market stocks (MSCI Emerging Markets index) gained 2.05% and 2.52% respectively.   Treasury yields made significant moves throughout the week but ultimately ended the week just slightly higher, helping to drive the Barclays Aggregate Bond index lower for the week at -0.25%.

Companies give out many forms of equity compensation. A common form of equity compensation is Restricted Stock. There are two main types of Restricted Stock, Restricted Stock Awards (RSA) and Restricted Stock Units (RSU). We have already discussed RSUs and how they work in another article (please click here to see it). This article will discuss RSAs and the beneficial 83(b) election that can be made on them.

It was a poor week for the stock market, as segments across the board experienced pullbacks. The S&P 500 retreated -4.73% for the week, with the biggest detractors coming from the materials (-6.64%), communications services (-6.42%), industrials (-6.37%), real estate (-6.23%), and technology (-6.11%) sectors. Consumer staples (-3.48%), financials (-3.77%), and utilities (-3.78%) held up better than the S&P 500 as a whole, but still sustained losses. The best sectors for the week were the healthcare (-2.32%) and energy spaces (-2.59%), but these rounded out a week that saw every sector of the large cap stock benchmark fall. U.S. small cap stocks outperformed their large cap peers by a small margin, ending the week down -4.46%. Stock markets overseas showed better results but still saw weekly losses. International developed stocks (MSCI ACWI ex US index) ended the week down -2.76% while emerging market stocks (MSCI Emerging Markets index) outperformed developed markets with a loss of -2.61% for the week. A likely partial catalyst for these losses was a continued rise in bond yields, with the 10-year treasury yield closing at just under 3.45%. The rise in yields coincided with the Barclays U.S. Aggregate Bond Index declining -0.93%.

You might have been told at some point in your life that there is a simple calculation you may use to determine how you should allocate your assets between equity and fixed income assets. This formula is rudimentary and does not consider your personal retirement goals or risk appetite. This equation has misled investors for years and can cause you not to have sufficient assets to meet your goals or leave you awake at night, fearing that your accounts are too volatile or risky.

As we reach the end of the year, a tax topic that will be discussed more will be the IRS 401(k) contribution limits. This contribution limit has a significant impact on your retirement savings and the strategies that are available to you. The 401(k) contribution limits for 2022 are as follows:

A beneficial tax planning strategy is available for high-income earners Level 67 or higher at Microsoft through Microsoft’s Deferred Compensation Plan (DCP). This plan allows high-income earners to shift income earned in years where they might be in higher tax brackets to years when they will hopefully be in lower tax brackets. The DCP can be very complex, and it is advised that you talk to a financial planner to discuss all of the benefits and options available to you.

Stock compensation plans of various types are a common method of compensation for valued employees of successful companies. Generally, these plans come in the form of Restricted Stock or Restricted Stock Units (RSUs), Incentive Stock Options, Non-Qualified Stock Options, or Employee Stock Purchase Plans. Receiving these corporate benefits is excellent for wealth accumulation, but it’s essential to understand how taxes are generated from these sources of income.

Definitions:

Grant Date: The date on which a company issues an equity compensation plan to an employee

Vesting Date: The date on which an ISO bearer may legally exercise their options or on which they receive their restricted stock units

Exercise Date: The date by which an employee uses stock options to purchase company stock

Vesting Schedule: A schedule by which an employee receives their equity compensation

Offering Period: The length of time after the grant date in which a stock option holder may exercise their options

Restricted Stock Units (RSUs):

These are stock units that are granted to an employee for the completion of certain performance milestones. This is the most straightforward form of equity compensation. These stock units are given to the employee as income on the shares’ vesting date. While employers usually withhold taxes on income, they do not adequately account for the vesting of RSUs each year which can lead to a hefty tax bill come tax time. The market value of the shares determines the tax of RSUs on the vesting date. Usually, the employee will immediately sell RSUs upon vesting to cover the tax bill they create. It is important to note that for vested RSU shares to qualify to be taxed at the preferential capital gains tax rates, they must be held for a year or longer after the vesting date. It is also important to note that the vesting of RSUs is considered income and is included on box 1 of your W-2.

Here is an example to outline how RSUs work and are taxed. Let’s say that Julian is granted 5,000 RSUs that vest at a rate of 20% yearly, and the market price at the grant date is $60 a share. The stock price the next year is $65. This means that in the first year of the stock vesting, Julian will show and be taxed on an additional $65,000. This amount will be shown on his W-2 box 1 wage. Let’s say the stock price stays at $65 for the remaining vesting schedule. This means that for five years in a row, Julian will show an additional $65,000 of income on his W-2 but not actually receive cash for the income (this is why many people immediately sell some shares to cover the tax liability created from the vesting of the shares). Then in year six, if Julian sells all 5,000 of the shares when the share price is $75 a share, he will recognize a $50,000 long-term capital gain (Basis of 5,000*$65 = $325,000 sell price of 5,000*$75 = $375,000). Please see Exhibit 1 below for a visualization of this example.

A similar equity compensation tool to RSUs is RSAs. This stands for Restricted Stock Awards and looks and acts very similarly to RSUs with a couple of key differences. RSAs are also eligible for the 83b election, which is a tax planning tool that allows you to make a tax payment at the grant date instead of the vesting date. For more information regarding Restricted Stock, RSAs, and the 83(b) election, please see our article on this topic.

 

Incentive Stock Options (ISOs) & Non-Qualified Stock Options (NQSOs):

These stock options tend to be more complex in nature. An ISO is a right an employer gives an employee to buy stock in the company at a later date for a price equal to or more than the stock’s market value at the time of the initial agreement. ISOs have a required vesting period of two years and a hold period of more than one year before they can be sold at the preferential capital gains tax rates. If an ISO is not held for more than a year past the exercise date and two years from the grant date, it will be subject to ordinary income tax rates. It is important to note that ISOs terminate three months after employment with a company ends, so if you were to leave a company, your ISOs would end. There is also favorable tax treatment with ISOs. There is no tax when the options are granted or exercised. Tax is only realized when the stock is sold, and most likely, it will be at the capital gains tax rates. There is an Alternative Minimum Tax (AMT) implication to consider with ISOs. In the year the ISO is exercised, there will be a gain created for AMT. This gain will be the difference between the stock price at the grant date and the price at the exercise date. This AMT number will only impact an employee when they are highly compensated and have substantial options awarded. Please note that you can only exercise $100,000 in ISOs annually.

Here is an example to outline how ISOs work and are taxed. Let’s say Becky is granted an ISO to purchase 2,000 shares of her company’s stock at the current market price of $20. The stock vests two years after the ISO was granted to Becky when her company’s stock price has risen to $25 a share. Becky then exercises 1,000 of the stock options and purchases 1,000 shares of the stock for $20,000 (1,000*20). That year on Becky’s tax return she will need to show a $5,000 gain for AMT purposes (1,000*25 = 25,000 minus 1,000*20 = 20,000). Then after Becky has held the stock for a year, she sells it when the price is $30 a share, and she will show a long-term capital gain of $10,000 (1,000*$30 = $30,000 minus 1,000*$20 = $20,000). This is the most tax-efficient way for Becky to exercise her options. If Becky were to sell the shares before she held them for one year after exercising her options, then the $10,000 will be counted as ordinary income to her and taxed at a higher tax rate.

Please see exhibit 2 below for a visualization of this example.

NQSOs are more common and simple stock options than ISOs. NQSOs like ISOs give an employee the right to purchase a set number of shares within a designated timeframe at a predetermined price. Like ISOs, the predetermined price must be the same as or greater than the market price on the grant date of the NQSOs. The difference in taxation between ISOs and NQSOs comes into play when the stock options are exercised. While the difference in stock appreciation between the exercise and market price is shown as an AMT adjustment for ISOs, they are fully taxable as ordinary income and subject to payroll taxes for the employee and employer with NQSOs.

Let’s revisit Becky’s example and assume that instead of her options being qualified ISOs, they were NQSOs. This means that at the grant date, ISOs and NQSOs look identical. Then, in year 3 when Becky exercises 1,000 shares for $20 a share when the market price is $25 a share, she will have to pay taxes on the $5,000 appreciation (1,000*$25 = $25,000 minus 1,000*$20 = $20,000). This $5,000 appreciation will be shown on Becky’s W-2. Please see exhibit 3 below for a visualization of this example.

Employee Stock Purchase Plans (ESPPs):

ESPPs are taxes similarly to ISOs. They are limited to $25,000 exercised annually, and the employer can only give a maximum of 15% discount on the stock. They have the same holding period requirements as ISOs in that they must be held for at least a year after being exercised to qualify for the preferential capital gains tax rates.

Last week saw the S&P 500 break its streak of positive weekly returns. The index ended the week with a -1.16% return. The biggest detractors in the weekly decline were the communication services and materials sectors which lost -3.28% and -2.43% on the week respectively. Positive returns for the week came from the utilities, energy, and consumer staples sectors (1.28%, 1.30%, and 1.97% respectively). The week’s decline in stocks was not limited to large cap stocks in the U.S. Small cap stocks, per the Russell 2000, experienced steeper declines with the index finishing the week down -2.90%. International developed and emerging market stocks also showed weakness relative to the S&P 500. International stocks via the MSCI ACWI ex US index were down -1.94% while emerging market stocks fell -1.47%. In addition to the decline in stocks, Barclays US Aggregate Bond Index also finished the week with a decline of -0.89% as 10-year Treasury Yields ended the week higher.