Supercharge Your Savings with a Roth Account and Demystifying Stock Options
Two Ideas to Consider Heading into 2024
Provide Yourself Flexibility: Embrace Both Traditional and Roth 401(k)s
When it comes to retirement planning, or life in general, flexibility is often the key to financial success. Rather than choosing between a traditional or Roth 401(k), consider the power of both. Here are five reasons why you should embrace a tax-exempt account in 2024:
Tax Diversification:
Traditional 401(k): Contributions are made with pre-tax dollars, reducing your current taxable income. However, withdrawals in retirement are subject to income tax.
Roth 401(k): Funded with after-tax dollars, providing tax-free withdrawals in retirement.
By having both types of accounts, you can still lower your tax bill today by making traditional 401(k) contributions, while also creating a tax-free bucket via a Roth 401(k).
Hedge Against Uncertainty:
Future Tax Rates: The United States’ federal deficit is unsustainable. It is likely they will have to increase tax rates in the future to tackle this issue. By creating a tax free bucket now, you hedge against paying higher taxes on your income during retirement. This may not be the case for everyone, but something to consider.
Income Planning Flexibility:
Tax-Advantaged Withdrawals: During retirement, having the flexibility to choose between taxable and tax-free withdrawals is huge. For example, if you anticipate a lower tax bracket in a particular year, you might opt for more traditional 401(k) withdrawals. Or if you need a lump sum in retirement, but are already showing a lot of income, you could then take from a Roth account, tax-free.
Accommodate Changing Financial Circumstances:
Income Fluctuations: Throughout your career, your income will vary. Having both types of accounts allows you to adjust your contributions based on your current tax situation, ensuring you benefit from tax advantages regardless of your income level.
Legacy Planning:
Estate Planning Advantages: Roth 401(k)s do not have required minimum distributions (RMDs). A lot of people will leave a Roth account to their beneficiaries, which is tax-free for them.
Demystifying Employee Stock Options: A Comprehensive Guide
Do you get offered stock options as part of your compensation? While they provide an opportunity to gain equity in the company, it is crucial to understand the nuances of different stock options, how they operate, and their tax implications.
Restricted Stock Awards “RSUs”: Restricted stock awards and restricted stock units (RSUs) always have value and, unlike stock options, you don’t have to buy them. RSUs vest over time and are considered ordinary income in the year that they vest. When you think of RSUs, just think more income. Companies will typically sell shares to withhold taxes for you, although this is usually a flat percentage. So if you have a large number of RSUs vesting, monitor your income level as you don’t want a surprise tax bill at the end of the year. Holding onto RSUs after vesting results in capital gains or losses upon selling. Holding for over a year may qualify for long-term capital gains tax rates.
This is a helpful summary:
Incentive Stock Options “ISOs”: ISOs give you the right (not the obligation) to purchase your company’s stock, typically at a discount, at a specified price (strike price). In order to qualify for more favorable tax treatment, it is often recommended that you hold the shares for one year and one day from when you exercised and 2 years from the grant date. This will usually result in a lower tax bill. Typically, you must exercise ISOs within 10 years from the grant date or they expire.
Here are the 2024 long-term capital gains tax rates compared to ordinary income:
You are liable to pay taxes on the difference between the ultimate sale price and the strike price. If there is a large spread between the exercise price and the FMV of the company on the exercise date, you may trigger alternative minimum tax (AMT). You will want to consult someone to see if you are liable to pay AMT. Typically, you want to exercise your options during Q1 to help you plan and see how the stock performs during the year. For example, if you exercise ISOs in January, and then sell those shares in December, you will not be liable to pay AMT.
Not sure if you should exercise your ISOs? Reach out to me.
Nonqualified Stock Options “NSOs”: NSOs are essentially a deferred bonus, allowing employees to choose the year in which they pay taxes. These are taxed as ordinary income at the time of exercise, with no AMT implications. The tax liability is based on the difference between the grant price and the stock price at exercise. NSOs provide flexibility to sell immediately or hold onto the shares. The primary tax planning involves exercising and selling in years with lower tax brackets.
Is one better than the other? If you have the option to choose, the order of preference I would recommend:
ISOs - They are subject to MOST taxes (Federal and state)
RSUs - They are subject to ALL taxes (Federal, state, social security and Medicare)
NSOs - They are subject to ALL taxes (Federal, state, social security and Medicare)
For most people, this stuff is a foreign language but can provide you with significant financial options. Understanding the tax implications and differentiating between NSOs, ISOs, and RSUs helps you make informed decisions.
If you would like to schedule a call to walk through this together, here is a link to my schedule:
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Disclosure: This material is for general information only and is not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.
All indices are unmanaged and may not be invested into directly.
All investing includes risks, including fluctuating prices and loss of principal.