Morgan Stanley
  • Wealth Management
  • Jul 2, 2021

Using Equity Compensation to Optimize U.S. Federal Income Taxes

Using an effective tax management strategy for your equity compensation can not only reduce your tax liabilities but can also enhance your after-tax returns. Here’s a look at four strategies you may want to consider.

If you’re hoping to use your workplace equity compensation to help you achieve your financial goals, it’s important to make sure that you have a strategy to manage your tax obligation as well.

The tax treatment of your equity award will depend on the type of award you receive, as well as how long you hold the shares underlying your equity award and what happens to the share price during that time.

Still, understanding the tax treatment of your equity-based compensation - especially after a year of stock market volatility—can be confusing. Just one in three people who receive equity compensation feels that they have a strong understanding of the way that taxes can impact their specific type of stock plan benefits.1

A Financial Advisor can help you best determine when to sell or hold your equity award given your financial situation and goals, and a tax professional can help you identify your best tax moves. Still, having an understanding of the choices available can help you be better prepared for these discussions.

Here’s a look at four tax strategies to consider:

When to exercise your stock options

Stock options give you the right—but not the obligation—to purchase shares at a predetermined price within a fixed period of time. If you have stock options, you must generally hold them for a specified period of time before you can exercise them and purchase the underlying shares. Stock options typically expire if they are not exercised within a certain window (if you choose to exercise them at all).

A stock option may be worth exercising when the fair market value (FMV) of the underlying common stock at exercise is more than the exercise price.  For non-qualified stock options (NQSO), the difference between the FMV of the stock at exercise and the exercise price is taxed as ordinary income. Additional taxes may apply when you sell the shares. The tax treatment of incentive stock options (ISO) is based on the timing of exercise and when you sell your shares. By timing these transactions in years in which you have less taxable income and are in a lower tax bracket, you may be able to lower your overall taxable income and tax obligation.

Other tax management strategies

Once you’ve exercised your stock option award and purchased the underlying shares (if you have ISOs or NQSOs) or purchased shares under an employee stock purchase plan (ESPP), or your shares have otherwise vested (if you have restricted stock or restricted stock units), you can use some of the same tax management strategies that you would use for any equities in your portfolio. Here are a few to consider:

  • Holding shares for more than one year. Long-term capital gains are usually taxed at a lower rate than short-term capital gains, so, generally speaking, your tax burden will be lower if you sell your shares more than one year after you acquire the shares underlying your equity award. Certain additional rules apply to ISOs and shares purchased under a qualified ESPP in order to receive preferential tax treatment.

  • Tax-loss harvesting. This strategy involves selling shares at a loss in value. While it seems counterintuitive to lock in a loss, “harvesting” your unrealized investment losses allows you to offset capital gains with capital losses and minimize current tax obligations.  If you have offset all your capital gains and still have capital losses remaining, you can apply up to $3,000 of harvested losses to offset your ordinary income. Any additional unused capital losses can be carried forward to offset income or capital gains in future years.

    One thing to keep in mind: If you’re selling a stock for a loss, “wash” rules may prohibit you from recognizing that loss for tax purposes.  A “wash sale” can occur if you sell or trade stock or securities at a loss, then buy substantially identical stock or other securities within 30 days before or after the sale. If you are considering this as a tax management strategy, you should consult with your tax and Financial Advisors to confirm that the sale you’re considering is eligible.

  • Giving to charity: If you’re planning to give to charity, donating appreciated stock may allow you to make an even more valuable contribution while minimizing your income tax bill. If you give to a qualified charity, you don’t have to pay capital gains tax on the securities that you donate. Plus, you may be able to deduct the FMV of the stock on your tax return.

The Bottom Line

Equity compensation can be a powerful benefit that helps you to achieve your personal goals, so it’s important to consider it in the context of your broader financial plan. There are a variety of strategies you can execute that can help you reduce your tax burden in a given year. Many of these strategies are complex, so be sure to work with a tax advisor to see which make sense for your situation. The more you understand about these strategies, the more productive your discussions can be with your advisors.

Learn more about equity compensation and how Morgan Stanley can help.