Unless your company stock has poor fundamentals, it's pretty hard to beat a 15 percent return on your money before you even get started. This is because in most cases, Employee Stock Purchase Plans allow employees to buy their own company stock at a 15 percent discount from its current price.
Here is the catch; assuming the stock goes up, the dollar amount of the discount will be taxed as less tax favorable ordinary income, instead of being taxed as a long-term capital gain when the stock is later sold. The good news is that buying the stock at a 15 percent discount usually more than makes up for the higher tax rate.
Net Unrealized Appreciation
Remember also that at retirement or when you leave a company, there is a unique tax-break available for company stock held in a pre-tax company retirement plan. You are allowed to move the company stock in-kind, to a non-IRA brokerage account, instead of rolling it over to an IRA. This allows you to continue deferring tax on all the growth of that stock that occurred while in the company plan, until it is sold.
What's more, when you sell the stock, this growth, which is called net unrealized appreciation, will be taxed at the more favorable long-term capital gain tax rates, which are lower than the ordinary income tax rates you normally pay on withdrawals from company retirement plans or IRAs. This strategy can result in significant tax savings.
Keep in mind the original amount you paid for the stock inside your company plan will become taxable immediately as ordinary income and a 10 percent early payment penalty tax will be incurred if you're not age 55 or older when you withdraw the company stock.
Company stock can also be acquired by employees at huge discounts if their company offers stock options.
The most common type is the nonqualified stock option. This is where the employer offers the employee the opportunity to buy shares of the company stock at a pre-set price.
If the stock rises above that price, the employee still has the advantage of buying the stock at the preset lower price and putting the difference in his or her pocket.
For example, Jeff was given an option in year one to purchase 500 shares of ABC stock at the current market price of $50 a share. In year two he exercised part of his options and purchased 250 shares for $12,500 (250 × $50). The fair market value of the shares at the time of the purchase was $18,750 (250 x $75). Jeff now has a $6,250 gain because he was able to buy the stock at a discount by exercising his stock options ($18,750-$12,500).
Whether Jeff sells the stock right away or not, this $6,250 gain is taxable as ordinary income in the year the stock was bought.
If possible, it’s a good idea to exercise nonqualified stock options in years where you expect your income to be lower so you can trigger the tax in a lower bracket, and save on taxes.
An "incentive stock option" works the same way, except the employee does not recognize income or capital gains until the stock is sold; therefore they have the advantage of tax deferral. Also, if those shares are held for at least two years from the date the option was granted and at least one year from exercise, the tax on the sale will be payable as a more tax favorable long-term capital gain.
• Mike Piershale, ChFC®, RFC® is President of Piershale Financial Group. If you have financial questions on this column contact us at Piershale Financial Group, Inc., 407 Congress Parkway, Crystal Lake, IL 60014. You may also email Mike@PiershaleFinancial.com.