Are you lucky enough to be an employee who receives benefits in the form of equity? There is a mélange of ways companies can incentivize and reward their employees via equity, and employee stock purchase plans (“ESPPs”) are a well-known perk. This discussion will focus on qualified ESPPs, or Section 423 ESPPs, as they must meet regulatory requirements to offer tax advantages. In contrast, non-qualified ESPPs are more flexible regarding regulatory requirements but do not offer tax advantages. It is always prudent to check which type of plan you have before making any investment decisions.
ESPPs are relatively simple as far as contributions go. They are funded by after-tax payroll deductions and there is no withholding, not even for Social Security or Medicare. The deductions are held in the plan until a specified purchase date, at which point they are invested in company stock. Participants state the amount they want to contribute to the plan, which the IRS limits to $25,000 of the stock’s market value per year, and plans generally allow participants to elect deductions between 1% and 15% of a participant’s compensation.
ESPPs offer discounts and lookbacks. Most ESPPs build in a 10-15% stock price discount below market value. Then the lookback provision bases the purchase price not on the stock price at the time of purchase but on the price either at the beginning of the offering period or at the end of the purchase period, whichever is lower.
The tax treatment is a bit more complicated, but stay with me. When you sell the stock, you either pay ordinary income tax (called a disqualifying disposition) or long-term capital gains tax (called a qualifying disposition) on the gain, and you pay ordinary income tax on the discount. To receive the favorable long-term capital gains treatment, you have to hold the shares for more than one year from the purchase date and more than two years from the offering date. If you hold the shares according to these guidelines, you receive a lower percentage of ordinary income taxes and a higher percentage of capital gains taxes, which means you pay less in taxes overall.
Here’s an illustration of the tax treatment for both disqualifying and qualifying dispositions for those who are inclined.
Offering date price $10
Market price on purchase date $12
Purchase price @ 10% discount with lookback = $9
Sell price = $14
< 2 years from offering date and < 1 year from purchase date
Market price on purchase date – purchase price = ordinary income
$12 – $9 = $3 ordinary income
Sell price – tax basis* = short-term capital gain
$14 – $12 = $2 short-term capital gain
> 2 years from offering date and > 1 year from purchase date
Offering date price – purchase price = ordinary income
$10 – $9 = $1 ordinary income
Sell price – tax basis* = long-term capital gain
$14 – $10 = $4 long-term capital gain
*Tax basis = ordinary income + purchase price
In both examples, the tax burden is the same, a total of $5. However, the disqualifying disposition is broken down into $3 taxed at ordinary income rates and $2 taxed at short-term capital gains rates. The qualifying disposition is broken down into $1 taxed at ordinary income rates and $4 taxed at long-term capital gains rates. Therein lies the savings from observing the hold periods.
Let’s not forget about the discount either. While the 10% discount in the above examples may not seem like a significant amount, it can add up with share volume and is basically free money. What would you do if I offered to give you $10 in return for you giving me $9?
Accumulating shares over time through an ESPP can help build wealth. Still, you need to be careful not to end up with a concentrated position that exposes you to unnecessary risk should your company encounter adverse circumstances. You also need to account for your access to other stock-related benefits, including stock awards, restricted stock units, and stock options, and how this might add additional exposure. The key with all investing is diversification, so any ESPP holdings should be appropriately allocated within your global portfolio, which in and of itself should be rebalanced as your company holdings increase over time.
One of the top 10 questions I get from clients is should I open an HSA (Health Savings Account)? It is open enrollment season and HSAs have risen in popularity over the last few years, so let me take the opportunity to address the question here.
First, what are HSAs?
HSAs are personal savings accounts that can only be used for qualified health care expenses and out-of-pocket costs not covered by health plans. They offer tax benefits, spending flexibility, and portability.
Second, who is eligible?
To contribute to an HSA, you must be enrolled in a qualifying high-deductible health plan (HDHP). For 2022 the HDHP for individuals must have a deductible of at least $1,400 and an out-of-pocket medical expense limit of $7,050, and the HDHP for families must have a deductible of at least $2,800 and an out-of-pocket medical expense limit of $14,100.
Third, how do I get one?
You can enroll in an HDHP and an HSA through your employer if available, or find an HDHP on the health insurance marketplace and an HSA through a financial institution.
Here is a summary of the advantages and disadvantages of HSAs:
- If you make contributions with pre-tax dollars, they are excluded from your gross income.
- If you make contributions with after-tax dollars, you can deduct them from your gross income on your tax return.
- Contributions can earn interest and be invested.
- Your investments can grow and compound on a tax-deferred basis, which means there are no capital gains taxes on earnings.
- Withdrawals are tax-free for qualified health care expenses.
- You don’t have to make withdrawals in the year that the expenses are incurred (just save the receipts for the year in which you do make the withdrawals).
- Any unused money at the end of the year rolls over to the next year (unlike Flexible Spending Accounts (FSAs)).
- The account is always owned by you even if you change employers or terminate employment.
- When HSA money is used to pay for health care costs in retirement, it has more buying power than money from retirement plans like 401ks where you will owe income taxes on withdrawals.
- It can be challenging to budget how much to save as medical expenses are often unpredictable.
- HSAs have low contribution limits – the 2022 contribution limit is $3,650/year for individuals with additional catch-up contributions of $1,000 between ages 55 and 65. (This amount is reduced by any employer contributions excluded from gross income.)
- Once you enroll in Medicare at age 65 you can no longer contribute.
- If you withdraw funds for nonmedical expenses before age 65, you will have to pay income taxes on the money and an additional 20% penalty. If you withdraw funds for nonmedical expenses after age 65, you don’t have to pay a penalty but you will have to pay income taxes on the money.
For an HSA to be worth it, you should be relatively healthy and good with recordkeeping. If this describes you, consider adding HSAs to your financial to-do list. “I don’t like tax savings” said no one ever.
You are likely familiar with the concept of a power of attorney, a legal document that allows someone else to act on your behalf. Legal terminology denotes the individual designating the power of attorney the “principal” and the designated person the “attorney-in-fact”. There can be multiple attorneys-in-fact, but of course they must make decisions in concert. The scope of the power can be limited or broad, but the purpose is for the attorney-in-fact to make decisions that are in the best interests of the principal. A broad power of attorney is an attempt by the principal to give their attorney-in-fact the same rights the principal would have if they were able to act on their own behalf.
What does “durable” mean? A power of attorney goes into effect upon signing and terminates if the principal becomes incapacitated. Adding the durable specification means that the power of attorney will stay in effect if the principal becomes incapacitated. There is also the option to add a “springing” specification, which means that the durable power of attorney does not go into effect upon signing, but springs into effect if the principal becomes incapacitated. This addresses the situation whereby the principal wants to remain in control until they are unable to do so, and only at that point does the attorney-in-fact take over. While this is efficient, a drawback of the springing specification is that there could be disputes over whether or not the incapacity has occurred.
In addition to the durable financial power of attorney discussed here (also called a durable power of attorney for finances), there is a durable medical power of attorney (also called a durable power of attorney for health care). With a durable financial power of attorney, the attorney-in-fact has the right to pay bills, deposit checks, file tax returns, buy and sell real estate, invest in securities, make gifts, and even sue, among other things. As one would expect, with the durable medical power of attorney, the attorney-in-fact has the right to make health care decisions for the principal in the event of incapacity. Due to their different concerns, and even if the attorney-in-fact is the same for both of them, these two documents should be drawn up separately for purposes of privacy and simplicity.
Families can benefit from having a durable financial power of attorney in place if there’s a significant chance that an older family member will become incapacitated due to disability, illness, or age. A durable financial power of attorney can prevent the family from having to go through the court system to appoint a guardian or conservator to manage the principal’s financial affairs. Additionally, a durable financial power of attorney can make it easier for a family member to take the helm and avoid conflict with other family members.
You don’t have to be older to benefit from having a durable financial power of attorney in place, because you never know if an accident might happen that could lead to your own incapacity and leave financial chaos behind. For example, it’s common for spouses to have durable financial powers of attorney for one another in case something happens to one of them. In community property states especially, many transactions require the signature of both spouses, and so it’s prudent for spouses to confer durable financial power of attorney upon one another. Some community property states such as California already provide that if one spouse becomes incapacitated, the other spouse automatically assumes the management of the community property. Which, to avoid conflict, makes it important that the other spouse and the attorney-in-fact are the same person.
In your suite of estate planning documents, a durable financial power of attorney could be an essential one.
Another day, another acronym. The financial industry is rife with them, causing cringes, confusion, and avoidance, so I try to assume the mantle of translator from time to time. RMD is an important term to know, particularly if you’re approaching retirement, or if you’re already in the thick of it. RMD stands for Required Minimum Distribution, and it is the amount that the IRS requires you to withdraw from your tax-deferred retirement accounts when you turn 70 ½. Tax-deferred retirement accounts include qualified defined contribution plans (401(k)s, 403(b)s, 457s, and Thrift Savings Plans), as well as the basket of IRAs (Traditional, Rollover, SEP, and Simple). (There is one conspicuous exception in the lineup here – RMDs are not required for Roth IRAs since they are funded with after-tax money and therefore are not tax-deferred.) The catch here is that the RMD is tax-deferred money, so you will be liable for taxes on it at ordinary income rates.
There are two options for when you can take your first RMD. The first option is to take it anytime in the year that you turn 70 ½. The second option is to take it by April 1 of the year after you turn 70 ½. Initially, the second option seems like a boon, as it delays the administrative work and the tax hit into the following year. However, doing this can cause a much higher tax bill the following year, as you will also need to take your second RMD that same year. The result could even push you into a higher tax bracket, which should be avoided if possible.
A common question is, what happens if I have a motley crew of retirement accounts, do I have to take a separate RMD for each account? Well, you can combine all your IRA account balances and take one RMD from one of the IRAs, and combine all your 403(b) account balances and take one RMD from one of the 403(b)s, but if you have another kind of qualified defined contribution plan like a 401(k), you have to take the 401(k) RMD from that account only. So the answer is yes, aggregation is possible, but it depends on the account type.
If you’re still working at age 70 ½, your qualified defined contribution plan may allow you to defer taking your RMD until you actually retire, so it is worth checking with your plan administrator about this. It is generally prudent to continue realizing the benefits of tax-deferred compounding until you have to stop. If you’re still working at age 70 ½ and own more than 5% of the business, you can’t defer taking your RMD until retirement. Furthermore, your ownership can be attributed to your spouse and/or children also employed by that same business, and can prevent them from deferring their RMDs until retirement as well.
If for some reason (including but not limited to the cringes, confusion, and avoidance mentioned above) you missed the deadline to take an RMD, the IRA penalty is particularly harsh – 50% of the amount that you owe for the RMD. For example, if your RMD is $5,000, you would owe the IRS a hefty $2,500 (plus the tax you owe on the RMD itself). Of course, this money would be much better spent on… almost anything else.
How are RMDs calculated? Turns out it’s not an onerous process of sifting through IRS tables or identifying correct distribution factors, as the Internet is benevolent. I like Charles Schwab’s online RMD Calculator, which is simple and user-friendly. All you have to do is input your account balance as of 12/31 of the previous year, your date of birth, your primary beneficiary and their date of birth, and the rate of return you expect to receive on the account, and ta-da your RMD is calculated. The last thing to note here is that you are not limited to the RMD amount at any time – you can take out as much as you want, even the whole ball of wax. The piper – ahem the IRS – certainly won’t stop you as they are happy to collect the taxes whenever you are ready to pay them.