Maximize Your Equity Compensation: The Power of the 83(b) Election
Equity compensation can be an incredible tool for building wealth, especially for startup founders and employees in fast-growing companies. But with this opportunity comes a complex tax landscape that can significantly impact your financial outcomes. One powerful strategy to manage taxes effectively is the Section 83(b) election.
Equity compensation can be an incredible tool for building wealth, especially for startup founders and employees in fast-growing companies. But with this opportunity comes a complex tax landscape that can significantly impact your financial outcomes. One powerful strategy to manage taxes effectively is the Section 83(b) election.
Filing an 83(b) election at the right time can save you thousands, if not more, in taxes. It allows you to pay taxes on the value of your stock when it's granted, not when it vests—helping you lock in lower tax rates while the stock’s value is still low.
In this guide, we’ll explore how the 83(b) election works, who should consider it, and how to decide if it’s right for you. We’ll also compare two scenarios—using the 83(b) election versus not using it—so you can clearly see the potential savings.
What is the 83(b) Election?
The 83(b) election is a choice you can make when you receive restricted stock or stock options as part of your compensation package. Without the election, you would pay taxes on the stock’s value when it vests—usually when the stock’s value is much higher.
The 83(b) election allows you to pay taxes upfront on the stock’s current value, at the time of the grant. If the stock grows in value, you pay less in taxes overall because the appreciation is taxed as long-term capital gains rather than higher ordinary income rates.
In short, the 83(b) election lets you lock in lower tax rates by paying taxes now instead of later when the stock’s value could be significantly higher.
Who Should Consider Filing an 83(b) Election?
Filing an 83(b) election can make a lot of sense for:
Startup founders who are granted stock when the company is just starting and stock values are low.
Employees receiving restricted stock units (RSUs), restricted stock grants (RSGs), or stock options as part of their compensation.
People exercising incentive stock options (ISOs) or non-qualified stock options (NSOs) early, allowing them to benefit from potential long-term capital gains.
However, the 83(b) election isn’t for everyone. If the stock doesn’t grow in value, or worse, if the company fails, you’ll have paid taxes on a higher value than the stock is eventually worth. This is why careful consideration and professional guidance are essential.
Filing the 83(b) Election: Timing is Everything
The IRS gives you 30 days from the date you receive your stock to file an 83(b) election. Miss this deadline, and you lose the opportunity to make the election.
Once you decide to file, here are the steps:
Fill out IRS Form 83(b): This form must include details such as the number of shares, the date of grant, and the value of the stock.
Send it to the IRS: You’ll need to send the form to the IRS within 30 days of receiving the stock.
Send a copy to your employer: They need to have a record that you’ve made the election for tax reporting purposes.
Keep a copy for yourself: Always keep a copy of your 83(b) election form in case you need to refer to it later.
If you miss the deadline, there is no extension and no way to retroactively file an 83(b) election. In this case, you will be taxed on the stock’s value at vesting, which can result in a much larger tax bill if the stock appreciates.
Why the 83(b) Election Can Save You Money: A Real-World Example
Let’s look at a simple example to illustrate the potential savings from filing an 83(b) election. Imagine you’re granted 10,000 shares of stock at a value of $1 per share. Three years later, when the stock vests, it’s worth $10 per share. Here’s how the numbers break down in two different scenarios: one where you file the 83(b) election, and one where you don’t.
Scenario 1: Filing the 83(b) Election
At the time of the stock grant:
You decide to file the 83(b) election and pay taxes on the stock’s value at the time of the grant.
Total taxable income = 10,000 shares × $1 per share = $10,000.
You pay ordinary income tax on this amount. Assuming a 37% tax rate, your tax bill is $10,000 × 37% = $3,700.
When the stock vests:
Since you’ve already paid taxes on the stock at the lower $1 per share value, you owe no additional taxes when the stock vests.
When you sell the stock:
After the stock vests, you sell it at $10 per share.
The difference between the sale price and the value you paid taxes on is considered a capital gain.
Capital gain = (10,000 shares × $10) - (10,000 shares × $1) = $90,000.
You pay capital gains tax on the $90,000 at the long-term capital gains rate of 20% ($90,000 × 20% = $18,000).
Total tax bill:
Tax paid upfront: $3,700.
Capital gains tax: $18,000.
Total taxes paid = $21,700.
Scenario 2: Not Filing the 83(b) Election
At the time of the stock grant:
You don’t file the 83(b) election, so you don’t pay any taxes upfront.
When the stock vests:
You are taxed on the stock’s value when it vests, which is now $10 per share.
Total taxable income = 10,000 shares × $10 per share = $100,000.
You pay ordinary income tax on this amount at a rate of 37% ($100,000 × 37% = $37,000).
When you sell the stock:
Since the stock’s value hasn’t increased after vesting, there’s no capital gain, and no additional tax is owed.
Total taxes paid = $37,000.
The Big Difference: $15,300 Saved
By filing the 83(b) election, you saved $15,300 in taxes. The reason? You locked in the lower tax rate on the stock when it was worth less. Without the election, you had to pay taxes on the higher value at vesting.
What if You Miss the 83(b) Deadline?
If you miss the 30-day deadline to file the 83(b) election, there’s no way to retroactively file. However, this doesn’t mean you’re out of options. There are still other tax strategies to explore that can help reduce your tax burden, such as:
Maximizing capital losses: If you have other investments that have lost value, you can use those losses to offset some of the taxes owed on your stock gains.
Strategic stock sales: If you don’t file the 83(b) election, you may want to consider selling your stock over time to spread out the tax liability.
In any case, missing the deadline should prompt a larger conversation with your financial advisor about the best way to manage your stock compensation moving forward.
The Bottom Line: Get Professional Guidance
Filing a Section 83(b) election can significantly reduce your tax liability, but it’s a decision that shouldn’t be taken lightly. While it can save you a lot of money if your stock appreciates, it also comes with risks. If the stock decreases in value or the company fails, you’ll have paid taxes upfront on an overvalued stock.
To make the best decision for your situation, it’s important to work with a financial planner who understands the complexities of equity compensation and taxes. At Wysopal Wealth, we specialize in helping equity-compensated individuals and startup founders navigate these decisions. We’ll help you determine whether the 83(b) election is right for you and create a plan that aligns with your long-term financial goals.
Key Takeaways:
83(b) election: Lets you pay taxes on stock when granted, locking in a lower rate.
Who should consider it: Founders, employees with restricted stock, and those exercising options early.
Missed deadline: No retroactive filing, but other tax strategies can help.
Consult a professional: Work with a financial advisor to make the right decision.
Think an 83(b) election may be right for you? Book an Intro call to find out.
Tax Diversification Within Your Portfolio and Balance Sheet
Tax diversification is a crucial but often overlooked aspect of financial planning. By strategically spreading your investments across different tax treatments, you can enhance flexibility, minimize tax liabilities, and maximize long-term wealth. Understanding how to incorporate tax diversification within your portfolio and balance sheet can help you optimize financial outcomes and maintain tax efficiency over time.
Tax diversification is a crucial but often overlooked aspect of financial planning. By strategically spreading your investments across different tax treatments, you can enhance flexibility, minimize tax liabilities, and maximize long-term wealth. Understanding how to incorporate tax diversification within your portfolio and balance sheet can help you optimize financial outcomes and maintain tax efficiency over time.
The Importance of Tax Diversification
Tax diversification plays a vital role in long-term financial security. By strategically allocating your investments across different tax categories, you can significantly reduce your tax burdens in retirement. A well-diversified tax strategy also provides flexibility when withdrawing income, giving you greater control over taxable income in different market conditions. Additionally, tax diversification helps hedge against future tax law changes, ensuring that your portfolio remains resilient even as tax policies evolve.
Understanding Different Tax Buckets
To effectively implement tax diversification, it is important to understand the three primary tax categories where your investments can reside: taxable, tax-deferred, and tax-free accounts.
Taxable Accounts
Taxable accounts include brokerage accounts and other investment vehicles that do not receive tax-advantaged treatment. While these accounts are subject to capital gains tax on any realized gains, they also provide advantages such as liquidity and flexibility. With proper planning, tax-efficient strategies like tax-loss harvesting can help minimize tax liabilities in these accounts.
Within taxable accounts, the most tax-efficient investments are those that generate long-term capital gains rather than ordinary income. Examples of suitable assets include individual stocks, index funds, and tax-exempt municipal bonds. These investments minimize tax consequences while allowing funds to grow efficiently. In contrast, actively managed mutual funds, REITs, and high-turnover investments should generally be avoided in taxable accounts since they can generate high taxable distributions. Research has shown that holding equities in taxable accounts can be beneficial when turnover is low, as it avoids converting preferential capital gains treatment into ordinary income taxation.
Tax-Deferred Accounts
Tax-deferred accounts, such as 401(k)s, and traditional IRAs allow contributions to grow without immediate tax implications. Contributions to these accounts may be tax-deductible, reducing your taxable income in the year of contribution. However, withdrawals in retirement are taxed as ordinary income, so it is crucial to plan strategically to manage future tax liabilities.
Investments best suited for tax-deferred accounts include those that generate high taxable income, such as bond funds, real estate investment trusts (REITs), and actively managed mutual funds. Since these accounts defer taxes until withdrawal, income-generating investments can grow without immediate tax consequences, making them more effective within tax-deferred structures. Placing high-turnover investments in tax-deferred accounts is often preferable.
Tax-Free Accounts
Tax-free accounts, such as Roth IRAs, Health Savings Accounts(HSAs) and Roth 401(k)s, offer significant tax advantages. Contributions to these accounts are made with after-tax dollars, but qualified withdrawals, including both principal and earnings, are entirely tax-free. By incorporating tax-free accounts into your strategy, you can create a tax-efficient withdrawal plan in retirement, reducing your overall tax exposure.
Since Roth accounts provide tax-free growth, they are best suited for high-growth investments such as stocks, equity ETFs, and small-cap or emerging market funds. These investments have a higher potential for capital appreciation over time, maximizing the benefit of tax-free withdrawals. Additionally, Roth accounts do not have required minimum distributions (RMDs), allowing assets to grow indefinitely if not needed for retirement expenses.
Why Tax Diversification Matters
Having a diversified tax strategy ensures that you are not overly reliant on any single type of account, reducing potential risks and increasing financial flexibility.
Managing Future Tax Liability
By diversifying across taxable, tax-deferred, and tax-free accounts, you can prevent unexpected tax burdens in retirement. Strategic withdrawals from different account types can help you stay within lower tax brackets, ultimately minimizing lifetime tax expenses.
Enhancing Income Flexibility
Tax diversification provides you with the ability to withdraw funds from different accounts based on the most favorable tax treatment at the time. This flexibility allows you to better manage taxable income, avoid unnecessary taxes, and adapt to changing financial circumstances.
Optimizing Estate Planning
For those looking to pass wealth to future generations, tax diversification can play an important role in estate planning. By leveraging Roth conversions and other tax-efficient strategies, you can minimize the tax burden on your heirs, ensuring that more of your assets are preserved for your loved ones.
How to Achieve Tax Diversification
Achieving tax diversification requires careful planning and strategic decision-making.
Strategic Contributions
A well-balanced approach to contributions involves spreading investments across taxable, tax-deferred, and tax-free accounts. Taking advantage of employer-sponsored retirement plans, Roth IRAs, and brokerage accounts can ensure a diversified tax strategy that offers maximum flexibility.
Tax-Efficient Withdrawals
When planning withdrawals in retirement, prioritizing tax efficiency is key. Typically, withdrawing from taxable accounts first allows tax-advantaged accounts to continue growing. Additionally, Roth conversions during lower-tax years can reduce future tax burdens and enhance retirement income flexibility.
Common Mistakes to Avoid
Despite the benefits of tax diversification, many investors fall into common pitfalls. Relying solely on tax-deferred accounts can lead to significant tax burdens in retirement when required minimum distributions (RMDs) begin.Also ignoring what you want out of your life. For example, if you are looking for financial independence before full retirement age, you’re most likely going to need to build up a large taxable bucket of assets. Its hard to do this if you’re only putting money away into tax-deferred accounts. Ignoring Roth contributions or conversions can mean missing out on future tax-free income. Additionally, overlooking the tax implications of investment withdrawals can lead to unnecessary tax expenses that could have been avoided with proper planning.
Final Thoughts
Tax diversification is a powerful tool for financial stability and long-term wealth preservation. By structuring your portfolio and balance sheet strategically, you can mitigate tax burdens, enhance financial flexibility, and secure a more efficient retirement strategy. Taking the time to assess your current tax diversification strategy and making necessary adjustments can provide lasting financial benefits. If you need assistance in optimizing your tax strategy, consulting a financial professional can help ensure that your investments align with your financial goals.
Are you unsure if your portfolio is tax-diversified? Book an Intro call to see how you can optimize your tax strategy for a more secure financial future.