Top federal income rates are scheduled to rise from 36.45 percent in 2012 to 41.95 percent in 2013, including a Medicare tax rate increase. So for CEOs with nonqualified stock options, it may be beneficial to exercise them this year while tax rates are historically low.
So which options are candidates for early exercise? The simple answer is those with a value that has increased substantially since being granted and those that will expire in a few years. Of course, trading potential future appreciation in the option’s value for current tax savings should be weighed carefully.
Exercising an option in 2012 with a strike price of $20 and a current value of $40 could result in 9 percent more wealth compared to exercising at the same price in 2013.
Many CEOs may also have received restricted stock recently — or will before the end of 2012 — and should consider making an 83(b) election. That means choosing to report the stock as income before it vests. This must be done within 30 days after the grant date on unvested stock.
The advantage of an 83(b) election is getting to pay ordinary income tax on the asset this year — before tax rates rise in 2013. Even if the federal income tax rate does not increase, the new Medicare tax rate of 2.35 percent is coming. All future appreciation would be considered capital gains, which are currently taxed at a lower rate than ordinary income.
Of course, this strategy could have potential disadvantages. If the value of the restricted stock decreases, the tax on a depreciating stock would have been paid without taking advantage of the loss. And if the executive leaves the company before the stock vests, he or she will have paid tax on compensation never received.
Another strategy that many executives are undertaking this year is gifting assets to younger generations. Gifting is generally more tax efficient than a bequest, and the expected changes in tax rates and exemptions make it even more so now. This year offers a historically high lifetime gift tax exemption of $5.12 million per individual and $10.24 million for a married couple. Beyond the exemption amounts, the gift tax rate remains at a historic low of 35 percent.
Even if Congress extends today’s favorable transfer tax system, gifting now would still add substantial value if assets increase in value.
We are also in a very low interest rate environment, which provides some interesting ways to consider retirement planning. Upon retirement and when making deferral elections, executives need to decide how to receive their funds. Qualified and nonqualified plans provide the option of taking distributions in a lump sum or an annuity. Nonqualified plans also offer installment plans.
The simplest way to decide whether to take a lump sum versus an annuity or installments is to compare the annuity and installment payments to what might be generated by investing the lump sum at a similar risk level. Because the rate of return for an annuity is determined when selected, today’s low interest rates argue against an annuity, which typically doesn’t provide protection against inflation. So a lump sum may be the right option.
Also, since the value of lump sum payout from nonqualified plans depends on future interest rates, putting an interest rate swap in place can be a prudent strategy. Entering into an interest rate swap now can protect today’s value of lump sum payouts against a future increase in rates. If at retirement rates are higher than the swap rate, the investor will receive an offsetting gain. Of course, if at retirement interest rates are lower than the swap rate, then the investor would pay an offsetting loss but receive a larger lump sum.
While company insiders are barred from receiving nonqualified plan payouts for six months after their separation of service, their employers can provide some protection for payouts by distributing lump sum payments into a Rabbi Trust.
This year presents a number of historic opportunities to save on taxes. Staying on top of changes to the tax code and engaging in thoughtful retirement planning can make a big difference to your savings and what you pass onto your heirs. Time is running out on low tax rates and historically high exemption levels. And we cannot know when interest rates may move higher. A little planning now can make an enormous difference in your financial picture later.
Robert Barbetti http://www.jpmorgan.com/pages/jpmorgan/private_banking is an executive compensation expert within the Advice Lab at J.P. Morgan Private Bank, which develops wealth planning strategies for high and ultra high net worth clients.