Year-End Tax Planning - Aspiriant Wealth Management

Year-End Tax Considerations

For many investors, 2022 has been a year to forget. The long bull market came to a screeching halt as central banks have taken aggressive steps to tackle historically high inflation. Unlike in past bear markets, both stocks and bonds have declined steeply.

But there could be an upside to the downturn, particularly if you’re looking to reduce your tax burden. As year-end approaches, there are several tax-planning considerations to take into account. In this article, we dive into specific tax issues around lower investment returns and higher interest rates. We also discuss tax considerations around equity compensation, as well as how a year of rough investment returns can help reduce your future tax liability. But don’t wait too long — in many cases, you’ll need to take action before year-end to take advantage of these opportunities.

Tax loss harvesting

Like most investors, your portfolio balance is likely lower today than it was at the beginning of the year. Significant losses can be painful, but volatile times can also present opportunities. You can take advantage of tax loss harvesting, which involves selling investments (stocks, mutual funds, etc.) that have declined in value to offset gains in other areas. For example, presume that you’ve sold investment assets for a $10,000 gain for the year. Other investments in your portfolio have underperformed, and you take a capital loss of $25,000 after selling those assets. The result is a net $15,000 loss, and you’re not taxed on the $10,000 gain.

Of that $15,000 net loss, you can use $3,000 to offset other income for the year. In this example, you can also carry forward the additional $12,000 in losses ($15,000 loss – $3,000 for tax-year 2022) into 2023 to offset gains for next year. There’s no maximum amount of tax losses that can be carried forward into the future, so you can potentially use a rough year like 2022 to reduce the amount you owe Uncle Sam for many years ahead.

Roth conversions

Another strategy is to max out contributions to your Roth IRA, which is funded using after-tax dollars. Though Roth plans don’t offer tax benefits today, these accounts grow tax-free over time. This is a particularly valuable benefit for younger employees, where time is on your side for appreciation. There are also options to employ a “back-door” Roth strategy, which allows you to contribute to an after-tax Roth IRA even if you exceed IRS income limits (though you’ll want to discuss this with your tax advisor before embarking on this path).

Boosting yields

If you still have money sitting in a checking or savings account yielding next to nothing, you should put that cash to work. Thanks to the Federal Reserve’s five rate hikes this year, it’s possible to earn 2% to 4% with little effort or risk using high-yield savings accounts, certificates of deposits (CDs) or money market funds. Another option is the Treasury’s inflation-linked I bonds. Their interest rate is linked to the CPI (consumer price index) and changes every six months. On the first business day of May and November each year, the Treasury announces the rate that will apply to I bonds purchased within the next six months. Bonds purchased between Nov. 1, 2022, and April 30, 2023, will earn an annual rate of 6.89% for the next six months. Every six months after your purchase, the rate on your bond will adjust to the then-current rate.

Charitable giving and gifting

One additional way to lower your tax bill for 2022–2023 and beyond is to reduce your taxable income via deductions. For instance, you can make charitable donations to qualified organizations. Another option is to set up a donor-advised fund (DAF), which lets you make a tax-deductible donation this year and then provide grants to charities from the fund in the following years.

Families whose estates could be subject to estate tax may want to give some undervalued assets to their eventual heirs today, when the federal lifetime gift and estate tax exemption is at a record high: $12.06 million per person. This exemption will drop to $5 million plus an inflation factor after 2025, which would bring it to about $7 million in 2026, unless Congress changes the law.

If you have an asset whose value has dropped, you could consider gifting that asset. It will use less of your federal gift and estate tax exemption as a result of the drop in value of the asset.

Tax considerations for equity compensation

Certain types of compensation require special attention to avoid unwelcome surprises at tax time. In recent years, equity compensation—often called simply “stock options”—has become a larger component of pay packages for both established and start-up companies. According to a Charles Schwab study, equity compensation makes up roughly 33% of employees’ net worth, and 40% of millennials’ net worth. Equity compensation is popular because the structure helps align long-term corporate goals with individual incentives for personal and company-wide performance. We’ve written about stock options in several past fathom posts, including Managing Lock-Up Periods During Volatile Markets and Know Your Life Options with Stock Options.

Many recipients of stock options can be shocked when their taxes are due to find out they owe much more than they expected, even when markets have gone down in value that year. Here are some fundamentals to help you ask the right questions of your tax professional and wealth manager.

You need to know which type of equity compensation you have, as each one has different tax implications. Common types include incentive stock options (ISOs), non-qualified stock options (NQSOs), restricted stock units (RSUs) and employee stock purchase plans (ESPPs). Each type has specific tax rules, and even the same type of equity compensation can be taxed differently depending on when you exercise and sell shares.

For example, NQSOs are normally taxed as regular income at exercise, and then they can also generate short-term or long-term capital gains depending on the timing of when shares are exercised and sold. For ISOs, the difference between the strike price and the market value is subject only to the Alternative Minimum Tax (AMT), though there are additional tax consequences when the shares are sold. For RSUs, the value of the shares upon vesting is taxed as wage income.

It’s important to note that you could be stuck with an unexpectedly high tax bill from stock options even if their initial value has dropped considerably. Stock options are taxed on what they were worth when issued, even if their current price is far lower than their initial value. This means that the timing of exercising options can make a huge difference not only in terms of potential gains, but on your taxes as well. If you would like to learn more about minimizing taxes with your equity compensation, watch our webinar entitled “Equity Compensation – What You Can Do In a Down Market.”

If you exercised nonqualified or incentive stock options at the beginning of the year and haven’t sold the underlying stock, consider if it still makes sense to keep holding it. There could be regular tax as well as AMT issues. For example, in 2020, when the market was down, many people exercised stock options and got stuck with a tax liability they weren’t prepared for.

There are unique opportunities for equity compensation in a down market that can provide long-term tax minimization, diversification, and “double-discount” benefits. We encourage you to discuss your options (in both senses of the word) with your tax advisor.

Bright spots in a challenging year

As we’ve noted, there can be distinct silver linings to a down market from a tax perspective, ranging from tax loss harvesting to maxing out your after-tax contributions. But in most cases, you’ll need to act by December 31 to take advantage of these opportunities. While you may (understandably) be ready to put 2022 in the rearview mirror, if you wait until next year, it could be too late.