By Jake Withnell, CFP®
Taxes are an inevitable part of life, one that few people genuinely enjoy or seek to understand. As a successful executive, understanding your tax liability is one of the most important aspects of your wealth management plan, and it can also be one of the most complicated. Many people staunchly avoid thinking about their taxes until April 15th—but that often does more harm than good. Don’t wait to start planning for tax season. These are the top 4 tax issues I’ve seen executives face, and what you can do to overcome them.
1. Understanding Your Deferred Compensation
For executive employees, deferred compensation plans can be an effective way to save for retirement because they have no contribution limits. But the intricacies of these plans can be difficult to understand, especially as it relates to your tax bill.
Deferred compensation allows a portion of current earnings to be delayed until a later date (typically retirement) in order to avoid taxation in the current year. Since they have no contribution limits, they are especially attractive to executives and high-earning employees, particularly if they anticipate being in a lower tax bracket in retirement.
Keep in mind that while you are receiving tax deferral through this benefit, there is no guarantee you’ll actually receive the funds. The reason you are able to receive preferential tax treatment is because your employer simply “promises” to pay your compensation down the line; they are not legally obligated to keep this promise and may be unable to if they experience financial instability or bankruptcy in the future. When thinking about deferred compensation, be sure to assess your company’s viability and how it could affect your compensation in the future.
How and when to take your deferred compensation payout is another big question. Most plans allow you to take the payout as a lump sum (which could create a huge tax liability all in one year), or you can choose to take fixed annuity payments over the course of a set period of time (causing your tax liability to be spread out over several years). The best option to choose will depend on your specific financial situation, including other sources of retirement income, annual expenses, and long-term goals.
2. Accessing Cash From Illiquid Investments
As executive employees, many of my clients receive equity compensation, including stock options and restricted stock units (RSUs). I’ve found that they often don’t fully understand how these fit into their overall tax plan or when they can be converted to cash.
Stock options, for instance, can be exercised at any point after they are received and have fully vested. Once exercised, they can be sold on the open market for cash. The amount of tax due will depend on the type of stock option received (incentive or nonqualified) and how long the stock was held before sale.
RSUs are subject to vesting schedules based on length of employment or performance. Once the RSU has become fully vested, it’s usually converted to stock. At this point, you will be taxed on the market value of the converted shares. Understanding when this will happen is crucial to minimize your tax liability. For instance, if you expect a large portion of your RSUs to vest next year, you should try to minimize or defer other income to a different year so you’re not pushed into the next tax bracket.
If your RSUs don’t convert automatically, then deciding when to convert your options to stock becomes the question. Converting at the right time can help boost your returns and reduce tax liability. Waiting until share prices are depleted or when your taxable income is lower is often a great way to maximize your RSUs.
It’s also important to think through what you want to do with the stock once it has become available. Selling it within one year of conversion may result in capital gains that will be taxed as ordinary income, which can be as high as 37% for high-income earners. Holding it for at least a year, on the other hand, will allow any gain to be taxed at the preferential, long-term rate (typically 20%). Either way, fully integrating your equity compensation into your wealth management plan is a necessary step.
3. Diversifying a Concentrated Position
Many executives have built wealth through concentration in their company stock (through the equity compensation mentioned above), but few are able to preserve wealth over time while in such heavily concentrated positions. Worse yet, for too many, their stock never hits their anticipated peak, leaving their financial goals underfunded.
If the company performs poorly or there is an overall bear market, it will depress the stock price and you could be laid off at the same time. Without a solid wealth management plan, your personal income statement and balance sheet could be blown up all at once.
Diversification is necessary, but it can come with an unwanted tax liability, especially if your company stock is selling for much higher than it was worth when you received it. There are many tax-efficient ways to diversify a concentrated portfolio, including exchange funds and charitable trusts. You could also implement a phased approach to diversification where you slowly sell off your company stock to spread the tax liability over several years.
4. Maximizing Retirement Contributions
Just because you are an executive employee with a high level of income doesn’t mean that maximizing retirement contributions is easy. In fact, it’s another tax obstacle I’ve seen many executive employees face.
Annual contribution limits for retirement accounts are usually too low for you to make meaningful advances toward your retirement wealth. For example, the contribution limit for a 401(k) in 2022 is $20,500 (plus an additional $6,500 if you’re over 50). The contribution limit to an IRA is only $6,000 (or $7,000 if over 50).
Experts recommend that most people should contribute at least 15% of their income toward retirement, so we’ll use that benchmark as a simple example. If you earn $500,000 per year, you would need to contribute $75,000 per year to meet that 15% goal. Maximizing contributions to a 401(k) and a traditional IRA don’t even come close, so high-income earners need to find creative ways to save for retirement.
Additional forms of retirement savings can come from deferred compensation or equity compensation, each with their own tax challenges. You can also utilize a taxable investment account, but this may generate income and gains before retirement that will be taxable as current income. Avoid tax pitfalls by working with a qualified financial professional who can help you create a retirement savings plan based on your specific income level and future needs.
Do You Need Help With Some of These Tax Issues?
Do these tax issues sound familiar? If so, the JGP Wealth Management team is here to help. We specialize in working with high-net-worth individuals and successful executives, and we strive to help clients make the most of their wealth in a tax-efficient way. Don’t wait to start planning for tax season—reach out to me at 503-446-6450, email firstname.lastname@example.org, or schedule an introductory phone call online.
Jake Withnell is a financial advisor at JGP Wealth Management, an independent, fee-based financial advisory firm in Portland, Oregon. Jake is known for going the extra mile for his clients and for his passion for working tirelessly to help his clients find solutions to their financial concerns so they can confidently live out the life they want. He prioritizes listening and understanding as the foundation of his relationships with his clients, and his highest hope is that they can spend more of their time and energy on their passions knowing he is watching over their financial future. Jake specializes in serving business owners, Nike executives, and retirees, and plays a key role in JGP’s portfolio management process, building and analyzing financial models, and conducting client cash flow analyses.
Jake graduated from Eastern Washington University with a bachelor’s degree in professional accounting and finance. He is a Certified Public Accountant (CPA) and a CERTIFIED FINANCIAL PLANNER™ professional. Jake’s claim to fame is his time playing tight end for the Eastern Washington University Eagles, all while earning four-time Big Sky Conference First Team All-Academic honors! Jake values giving back to his community and does this by volunteering with the Children’s Cancer Association, Family Building Blocks, and New Avenues for Youth. In his free time, Jake takes advantage of the many outdoor activities the Northwest has to offer, such as trail running, mountain biking, and hiking. He loves traveling and spending long weekends at his family beach house in Seaside, OR. To learn more about Jake, connect with him on LinkedIn. You can also watch his latest webinar on 6 Ways to Maximize Your Nike Employee Benefits.