What could you do in this case?

[sheehs1]

So if I am to believe that I understand what was posted by MichaelB Hamlet and Sheehs1 then the vast majority of compensation is taxed at the same rates I pay and not at cap gains. Correct?

Correct RetireBy90. At some point, ordinary income tax rates are paid either when the grant invests or when the options are exercised. I'm not saying the CEO might not get a lower set point or price for execution...but they will eventually pay ordinary income tax rates.

However, the hedge fund managers and the private equity partners...might be a different story. I'm also not well versed in how they are paid. We could get into that one too for an increased understanding...if there is anyone on the board who falls into these categories who is willing to share the information

 

[Hamlet]

Well, ISO options can be taxed at long term capital gains rates, but as someone else said, they are becoming uncommon.

The big issue with options in the past was that CEO's were often getting them backdated to the lowest possible price in the grant period. It essentially amounted to stealing from shareholders, but I believe that practice has been put to a stop.

The hedge fund managers are getting a special deal that is completely immoral, IMO. They've bought a loophole from our Congress critters to allow them to essentially pay 15% rates on their ordinary income.

I don't think most CEO's are under-taxed. Overpaid maybe, but not under-taxed

I think the childeren of Sam Walton are under-taxed though. This idea that the owners of capital should get a free ride tax-wise is ridiculous, IMO.

Correct RetireBy90. At some point, ordinary income tax rates are paid either when the grant invests or when the options are exercised. I'm not saying the CEO might not get a lower set point or price for execution...but they will eventually pay ordinary income tax rates.

However, the hedge fund managers and the private equity partners...might be a different story. I'm also not well versed in how they are paid. We could get into that one too for an increased understanding...if there is anyone on the board who falls into these categories who is willing to share the information

 

[Texas Proud]

Thanks Hamlet. Interesting. So regardless at some point, ordinary income tax is paid on a stock option or grant. I get that the stock price can be manipulated or that the CEO may get it at a low set point..etc. but that doesn't seem to be anyones business. He/she will,at some point, pay ordinary income tax or give it to charity to get a tax deduction or whatever.

It is also relevant that whether it be an option or a grant, it carries the risk of loss. (Enron).

Is part of the argument then that a LARGE part of CEO income "could be" in these options/grants...so that eventually a LARGE part of their net worth, "once they have paid ordinary income tax on the option/grant..." is then subject only to the 15% cap gains or dividends on the growth of that basis?
But the point is well taken that at some point that did pay the ordinary tax rate.

How is this any different from anyone who inherits 2 million in cash (or less) and doesn't pay tax on it since the Unified Tax Credit is 3 million, chooses to invest it and only pays the 15% from that point forward?

So one point of the argument isn't really about stock options and grants ...is it? It is about anyone that accumulated "something", paid their fair share of ordinary income tax and is now taxed at 15%.

Sounds to me the like government and the current rhetoric is VERY short sited. If one looks at this in terms of "a curve", then one can make the argument that they are trying to "speed up" what they would get anyway over 1 to 30 years, in a sense. Speed it up AND get more. But it is the "get more" part that could back fire. They are trying to shorten the tax curve. Fair statement or not? Could this not lead to there being "less" in tax revenues down the road? If they take more now, then there possibly will be less to generate that revenue later. ummmmm....

Either that...or it is simply being used as a political tool, as a running platform or to deliberately shake things up.

Just want to make a point... if you have a option, there is no risk of loss.. if the price to exercise them is higher than the current price, like mine that are about to expire, you just do not exercise them and they disappear... I lose nothing except for the HOPE they would have value...

As for the stock grant, you do have the chance of losing... but if the value goes down before you get the stock, then your taxes are also lower... I only got a grant once and it was for only a few shares so not worth much (maybe $1,000)... but I did not pay that much attention to the taxability of them so I could be off a bit...


Edit to add: The reason that stock options and stock grants are used is that most of the time the stock value goes up... and with some companies up a LOT... so if the company does well, the employee does well... think Microsoft, Dell, (way back when) Google, Facebook (now) etc. etc... it means your final compensation can be a whole lot higher than what the company could afford paying cash...

 

[sheehs1]

Just want to make a point... if you have a option, there is no risk of loss.. if the price to exercise them is higher than the current price, like mine that are about to expire, you just do not exercise them and they disappear... I lose nothing except for the HOPE they would have value...

As for the stock grant, you do have the chance of losing... but if the value goes down before you get the stock, then your taxes are also lower... I only got a grant once and it was for only a few shares so not worth much (maybe $1,000)... but I did not pay that much attention to the taxability of them so I could be off a bit...

But Texas Proud...didn't you loose "the bonus" that was given in options.? While you may not actually have lost on a tax basis or income basis, if you were given them in lieu of a bonus...didn't you loose? If the bonus had been paid in cash you wouldn't have lost.

 

[Texas Proud]

But Texas Proud...didn't you loose "the bonus" that was given in options.? While you may not actually have lost on a tax basis or income basis, if you were given them in lieu of a bonus...didn't you loose? If the bonus had been paid in cash you wouldn't have lost.

Except for that one stock grant that was not worth much, the options I got were given to all employees.... it was not a bonus... My bonus was all cash as I was not in the upper ranks, but a low level slave...

But I do see your point...

 

[MichaelB]

Hedge fund and private equity managers compensation is conceptually different. The investment funds they manage are illiquid partnerships, and their primary pay is a share of profits, which is credited in their name to the fund they manage, so their pay is considered not salary but investment income, and it is taxed when they withdraw it from the fund, not when it is credited, at capital gains rates. It's a great deal if you can get it.

Do CEO's pay ordinary income taxes on all their stock based compensation? It is not possible to know, because we only learn of the tax avoidance schemes after they are successfully challenged by the IRS. Up to that point, they are confidential and few people know. What we do know is the cost to set up a tax scheme: >$1M. It needs a tax account to conceive it, a tax lawyer to review and approve it, and a broker or financial intermediary to set up accounts. Just the idea may be worth >$1M. It also requires the collaboration of the corporation granting the options or stock, because they must be transferable, which is not at all common. This is much more prevalent where the executive has an unusual amount of influence over the board: a family founded corporation, a founding CEO, or a tyrant. Or a spineless BoD. Personally, I do not believe most corporate executives or most corporate executive compensation engage in these practices.

 

[Hamlet]

I'm facinated that people are willing to pay hedge fund managers the way they do.

It's pretty typical that a manager gets 2% of the assets and 20% of any profits. That's a payment scheme that encourages extreme risk-taking.

Imagine that I'm a hedge fund manager with $100 million under management.
If I employ a sensible strategy that nets me a consistent 10% return, I will make $4.2 million for that year.

If I take that money and wager it on a hand of blackjack, my expected pay is $12 million dollars ($24 million if I win the bet, $0 if I lose).

If I take that money and wager it on a single number in roulette, my expected pay is $19.7 million ($750 million if I win the bet (1 in 38 times), $0 if I lose).

I am better off taking a terrible gamble in the hope of a huge payoff than investing sensibly.

Hedge fund and private equity managers compensation is conceptually different. The investment funds they manage are illiquid partnerships, and their primary pay is a share of profits, which is credited in their name to the fund they manage, so their pay is considered not salary but investment income, and it is taxed when they withdraw it from the fund, not when it is credited, at capital gains rates. It's a great deal if you can get it.

Do CEO's pay ordinary income taxes on all their stock based compensation? It is not possible to know, because we only learn of the tax avoidance schemes after they are successfully challenged by the IRS. Up to that point, they are confidential and few people know. What we do know is the cost to set up a tax scheme: >$1M. It needs a tax account to conceive it, a tax lawyer to review and approve it, and a broker or financial intermediary to set up accounts. Just the idea may be worth >$1M. It also requires the collaboration of the corporation granting the options or stock, because they must be transferable, which is not at all common. This is much more prevalent where the executive has an unusual amount of influence over the board: a family founded corporation, a founding CEO, or a tyrant. Or a spineless BoD. Personally, I do not believe most corporate executives or most corporate executive compensation engage in these practices.

 

[sheehs1]

Hedge fund and private equity managers compensation is conceptually different. The investment funds they manage are illiquid partnerships, and their primary pay is a share of profits, which is credited in their name to the fund they manage, so their pay is considered not salary but investment income, and it is taxed when they withdraw it from the fund, not when it is credited, at capital gains rates. It's a great deal if you can get it.

Do CEO's pay ordinary income taxes on all their stock based compensation? It is not possible to know, because we only learn of the tax avoidance schemes after they are successfully challenged by the IRS. Up to that point, they are confidential and few people know. What we do know is the cost to set up a tax scheme: >$1M. It needs a tax account to conceive it, a tax lawyer to review and approve it, and a broker or financial intermediary to set up accounts. Just the idea may be worth >$1M. It also requires the collaboration of the corporation granting the options or stock, because they must be transferable, which is not at all common. This is much more prevalent where the executive has an unusual amount of influence over the board: a family founded corporation, a founding CEO, or a tyrant. Or a spineless BoD. Personally, I do not believe most corporate executives or most corporate executive compensation engage in these practices.

To address the hedge fund and private equity partners, that is a good deal if you can get it.

Interesting that profits are characterized differently for hedge funds/private equity"partnerships" than for C corps or Sub S companies in the private sector. Owners of C corp companies can be taxed twice. Once at the corporate rate for what is sitting on the profit line. If they declare a dividend to owners, then it is taxed again at their individual rate.

This is the reason most small companies prefer S Corp status. The same money is only taxed once. S corp owners owe all tax due the Federal and State governments at their individual ordinary income tax rate. The corporation does not pay the tax.

But I also see in the case of hedge funds/private equity WHY "that profit" may be considered investment income, since it is "routed" back to the hedge fund/private equity firm and conceivably to strengthen the investment and not weaken it. I see where it may get a bit "grey" here. The owner does not or may not have control over how the money is routed, how it is titled..etc. It might be credited in his name but the fund may still be the owner until it is exercised. Don't know. Along this route, it sounds like it may not go into his hands directly such that he has a "personal" decision he can make about the funds. And perhaps that is why it is not characterized as ordinary income. Don't know.

And I am fairly confident there are internal rules and regulations about how much they can take out and when.

However, if no piece of this is EVER taxed at ordinary tax rates, this is a point I can disagree with and agree that at some point, the basis should be taxed at ordinary tax rates.

Is this something unique to hedge funds and private equity firms or is it unique to the "partnership designation? Do private sector partnerships also enjoy this re-characterization of profits from "profits" typically associated with ordinary income taxation to "investment" designation?

 

[MichaelB]

The logic behind taxing private equity and hedge funds as investment income is that the owners were the partners, so they were investing their own money, along with that of others. It did not view fund managers as employees receiving compensation. When private equity and hedge funds evolved into broad based investments opportunities with fund managers investing other people's money, the tax code was not updated to make the distinction. This is a true "loophole".

And I am fairly confident there are internal rules and regulations about how much they can take out and when.

I do not share your confidence.

Is this something unique to hedge funds and private equity firms or is it unique to the "partnership designation? Do private sector partnerships also enjoy this re-characterization of profits from "profits" typically associated with ordinary income taxation to "investment" designation?

Carried interest is pretty specific to private equity and hedge funds. Partnerships in general are subject to complex tax regulations, but there is a clearer distinction between general partners, who really are investors, and senior partners, who may be investors but are also employee managers.

 

[Koolau]

Just want to make a point... if you have a option, there is no risk of loss.. if the price to exercise them is higher than the current price, like mine that are about to expire, you just do not exercise them and they disappear... I lose nothing except for the HOPE they would have value...

As for the stock grant, you do have the chance of losing... but if the value goes down before you get the stock, then your taxes are also lower... I only got a grant once and it was for only a few shares so not worth much (maybe $1,000)... but I did not pay that much attention to the taxability of them so I could be off a bit...


Edit to add: The reason that stock options and stock grants are used is that most of the time the stock value goes up... and with some companies up a LOT... so if the company does well, the employee does well... think Microsoft, Dell, (way back when) Google, Facebook (now) etc. etc... it means your final compensation can be a whole lot higher than what the company could afford paying cash...

Texas Proud quote - Except for that one stock grant that was not worth much, the options I got were given to all employees.... it was not a bonus... My bonus was all cash as I was not in the upper ranks, but a low level slave...

But I do see your point... quote





My situation was the "worst" of both worlds. My Megacorp had "promised" us a 50% match on our 401(k)s but almost always gave us 100% match (in the good old days). When Megacorp fell on hard times, they temporarily did away with ALL match and gave us future stock options "instead". This happened several times (sometimes they did away with the "bonus" which was actually just a "hold-back" of our compensation). Unfortunately, not one of the options was EVER in the money. Even though the employees took significant hits (either "bonus" or match) they never saw a penny from the options. Very good deal for Megacorp. Other than the paperwork (and maybe a "little" employee good will) it cost them nothing. But, I'm not bitter!

 

[Texas Proud]

My situation was the "worst" of both worlds. My Megacorp had "promised" us a 50% match on our 401(k)s but almost always gave us 100% match (in the good old days). When Megacorp fell on hard times, they temporarily did away with ALL match and gave us future stock options "instead". This happened several times (sometimes they did away with the "bonus" which was actually just a "hold-back" of our compensation). Unfortunately, not one of the options was EVER in the money. Even though the employees took significant hits (either "bonus" or match) they never saw a penny from the options. Very good deal for Megacorp. Other than the paperwork (and maybe a "little" employee good will) it cost them nothing. But, I'm not bitter!

Hey, I just checked... the stock price is only 21 cents less than the strike price!!! They expire next week, so here is hoping it goes up... but I only have a few hundred shares, so big whoop...

PS... I do not work for them anymore... so there is no more possibility of me getting any... I now work for a small closely held company and will not be getting anything but salary...

 

[Koolau]

This article should serve to remind us how lucky we LBYMers are that we often fall below the radar on tax issues. For example,
paying almost no tax on large Roth conversions.

Al, you obviously played the game the right way. Apparently, you kept back plenty of after tax sources to live on while being able to convert at a low tax rate. Good show. I did it wrong (at least in part) putting "too much" into 401(k) and leaving too little taxed money. That is why I always am the one who suggests those in the accumulation phase should be careful about going "all in" with their 401(k)/tIRAs. You prove the point that YMMV.

 

[sheehs1]

The logic behind taxing private equity and hedge funds as investment income is that the owners were the partners, so they were investing their own money, along with that of others. It did not view fund managers as employees receiving compensation. When private equity and hedge funds evolved into broad based investments opportunities with fund managers investing other people's money, the tax code was not updated to make the distinction. This is a true "loophole".

I do not share your confidence.

Carried interest is pretty specific to private equity and hedge funds. Partnerships in general are subject to complex tax regulations, but there is a clearer distinction between general partners, who really are investors, and senior partners, who may be investors but are also employee managers.

Got it! Or at least got the part discussed! Thanks MichaelB!

 

[sheehs1]

Al, you obviously played the game the right way. Apparently, you kept back plenty of after tax sources to live on while being able to convert at a low tax rate. Good show. I did it wrong (at least in part) putting "too much" into 401(k) and leaving too little taxed money. That is why I always am the one who suggests those in the accumulation phase should be careful about going "all in" with their 401(k)/tIRAs. You prove the point that YMMV.

Koolau. Exactly right. I had a conversation with a planner many years ago. Deferring compensation was based on the premise that tax rates would be lower in retirement. Well...that was too general a statement for me and not trusting the government and their regulations regarding IRA's and deferred compensation vehicles...I felt while it is a good idea to defer some...I felt it was a better idea...not to defer all.

 

[Hamlet]

I think it is hard for putting too much into a 401k to end up being a tax disaster, unless you have very low rates while accumulating or very high rates when withdrawing.

You may miss out on being able to convert cheaply, but the person who does convert cheaply is only able to do so because they paid income tax on their after tax sources long ago, and on any income generated by the investments along the way.

Am I missing a scenario?

Al, you obviously played the game the right way. Apparently, you kept back plenty of after tax sources to live on while being able to convert at a low tax rate. Good show. I did it wrong (at least in part) putting "too much" into 401(k) and leaving too little taxed money. That is why I always am the one who suggests those in the accumulation phase should be careful about going "all in" with their 401(k)/tIRAs. You prove the point that YMMV.

 

[ChiliPepr]

However, the hedge fund managers and the private equity partners...might be a different story. I'm also not well versed in how they are paid. We could get into that one too for an increased understanding...if there is anyone on the board who falls into these categories who is willing to share the information

What do you want to know? Hedge fund and Private equity are similar but slightly different.

In a hedge fund, the manager is usually paid "2 and 20", that means they are paid 2% to manage the money, this is usually what is used to "keep the lights on", pay base salaries, pay for research, analysis, bloomberg, and all the other expenses to run the firm. They are then paid 20% of any profits. Basically, this profit is then taxed in the same way the investor is taxed.

(There are A LOT of nuances I am skipping over in this example, like the Management fee is usually paid out quarterly not in a lump sum)
For example, If I invest 100k with a hedge fund, I pay $2k to the firm in management fee. So, my 100k is reduced to $98k. If at the end of the year, lets say my investment is worth 110k, made up of 100k initial investment + 2k Long Term gains + $15k Short Term + ($7k Unrealized loss) = $110k value. The Manager would then be paid $400LT + $3,000ST + ($1400 Unrealized) = $2,000 and would pay 15% on the LT, their "income" tax rate on the ST and nothing on the Unrealized because it is unrealized (they would pay taxes when it is sold).

 

[Koolau]

I think it is hard for putting too much into a 401k to end up being a tax disaster, unless you have very low rates while accumulating or very high rates when withdrawing.

You may miss out on being able to convert cheaply, but the person who does convert cheaply is only able to do so because they paid income tax on their after tax sources long ago, and on any income generated by the investments along the way.

Am I missing a scenario?

I do see your point and it is well taken. From my point of view, the "goal" is to end up with as much in a Roth (and, ultimately) as little in 401(k)s/tIRAs as possible because of their flexibility and tax advantages once obtained. The only comment I have on your premise is that doing BOTH (401(k) AND after tax) gives a lot more flexibility. If the rules change during the process, you have more ability to adjust. Who knows if it will turn out "better" to go this way, but it certainly would have for me in retrospect. Obviously, this would not be true for everyone - thus the value of your point of view.

But, to your specific question of another scenario. This one didn't actually work out for me, but the plan was to sell my appreciated house and use the proceeds (including tax-exempted gains) to pay the taxes on my conversions. I suppose you could still find a scenario within this scenario where tax deferral is "better", but it seemed like a good idea at the time. In fact, I did use my proceeds for early FIRE living costs and Roth conversion tax payments. The only thing that went "wrong" was that the house didn't appreciate. But, that was my plan. YMMV.

 

[Texas Proud]

Al, you obviously played the game the right way. Apparently, you kept back plenty of after tax sources to live on while being able to convert at a low tax rate. Good show. I did it wrong (at least in part) putting "too much" into 401(k) and leaving too little taxed money. That is why I always am the one who suggests those in the accumulation phase should be careful about going "all in" with their 401(k)/tIRAs. You prove the point that YMMV.

YES... I agree with this thought... I have heard so many people who 'max out' their 401(k) even though they are in the 15% bracket or even less.. the ROTH 401(k) has helped out, but I do not know if that many people are utilizing it... at my company only a couple of people are, but I guess that is 10%....

 

[ronocnikral]

another scenario in which one could be screwed, depending on how everything is calculated.

heaven forbid I kick the bucket, DW and 4 week year old DD (if in a couple of years, more kiddos on the way) collect the life insurance and depending on how they fare through the proceedings, their net worth is now over $3mil. That $3mil+ needs to last DW another 55-60 years, plus raise kids, put them through college etc.

Sure, DW and kiddos could be in a lot worse situation, but no one would envy their situation either.

 

[RetireBy90]

So since we are off topic completely from the original post and on to pre-post tax IRA/401K savings, I agree with those that put some in pre and some in post. I am being taxed today at 28% marginal rate, so my analysis says no way I'll make the same taxable rate in retirement, take the tax break now and go traditional. Then came to ask what if tax rates go up, so figured Roth. Then what if they do this national sales tax / VAT thing, so pay taxes now while I can afford it. Then back with what if I pay now and they somehow tax my Roth accounts for anyone making more than $1 a year, so back to traditional.

Who knows where taxes are headed. So now I'm doing Roth to get my Roth assets closer to 50%. In my case, since I'm doing both, I can't be all wrong (or I'm sure to be partly wrong?).

 

[Texas Proud]

So since we are off topic completely from the original post and on to pre-post tax IRA/401K savings, I agree with those that put some in pre and some in post. I am being taxed today at 28% marginal rate, so my analysis says no way I'll make the same taxable rate in retirement, take the tax break now and go traditional. Then came to ask what if tax rates go up, so figured Roth. Then what if they do this national sales tax / VAT thing, so pay taxes now while I can afford it. Then back with what if I pay now and they somehow tax my Roth accounts for anyone making more than $1 a year, so back to traditional.

Who knows where taxes are headed. So now I'm doing Roth to get my Roth assets closer to 50%. In my case, since I'm doing both, I can't be all wrong (or I'm sure to be partly wrong?).

You are right in that who knows what taxes will do... when I was in college I took a tax class (heck, I was a tax accountant for a few years)... but, the professor said his class was one of the few where he did not have to change his test questions, but the answers would change..

I also remember an estate tax professor say 'you have to plan the estate for the taxes today, but your plan might not be the best for them next year'.