The era of historically low income tax rates, when investors enjoyed a maximum tax rate of 15% on long-term capital gains from the most common assets, is likely coming to a close. After the ball drops on 2011, federal tax rates will likely revert to higher levels, with more increases expected in 2013 and afterward.
This new world of taxation might prompt executives with stock options to ask advisors when they should exercise those options, Barclays Wealth pointed out in its Wealth Advisory report, How to Handle Increasing Tax Rates-Sell or Hold?, published in late October. Holding the options allows executives to benefit from stock appreciation without a current expenditure. Yet doing so for too long can diminish the value of the options-rather counterproductive. Also, exercising options before they expire might mean giving up one of the financial instruments' principal economic benefits. Thus, the task facing advisors is to measure the tax burden of an options exercise.
Assume that an executive has stock options that are set to expire in 2011. That client faces two choices-exercise this year or hold the option for another 12 months. Also assume that the executive takes moderate risks when investing and expects his or her company's stock price to increase by 7% annually. Based on assumptions at Barclays Wealth, exercising the options in 2010 produces the better result. Retaining the option could put the executive in a better position financially if the single stock position substantially outperformed his or her diversified portfolio. Given the anticipated tax rates and an assumed pretax portfolio return of about 7.1%, the company stock would have to appreciate by 12.87% to make deferral worthwhile.
The picture changes if the executive waits to exercise the option. In fact, the tax-deferred return on the option trumps increased tax rates given the right time frame, and could deliver the most after-tax proceeds. Again, assume that an executive has a moderate investment portfolio and an expected return of 7% annually on a single stock, but with options that expire in 2015, instead of 2011. Although the effective tax rate in 2015 could be almost 48%-reflecting a New York state and New York City tax, plus federal levies on compensation for income scheduled for years after 2013-retaining the options gives the executive the better return. As the clock runs out on 2010, advisors and their clients should review their present and future tax situations carefully.
Matt Brady is head of Barclays Wealth Advisory, Americas, in New York City. Neither Barclays Wealth nor its employees renders legal or tax advice.