In this post, I try to answer the question, “Is it worth it to go through this process if we have to pay so much money in short term capital gains tax?”, and I think I am on to something in my justification, but it is never easy to see the money leave.
The Short term capital gains (STCG) tax rate is 25+%. Because it’s taxed as ordinary income it is the same as your income tax rate. Out of my $4,000 profit I could pay as much as $1,000! That stinks! But I would rather make the $3,000 than nothing at all.
As I have shown with my 2017 in-progress spreadsheet post, I am on track to nearly double ESPP profits by selling call options. Unfortunately, this means even more short term capital gains tax because option premiums can be nothing but a short term gain. Capital gains taxes cut into the bottom line, but even with these added expenses our return on investment is still very high! This brings us to the topic of long term capital gains (LTCG) taxes which range from 0%-20%, depending on your income bracket. LTCG are desirable because there is a maximum amount you can be taxed on your profit. And, if your income is within the 15% tax bracket, you pay no capital gains tax at all, which could be the goal of a retiree.
The reason I do not currently take advantage of long term capital gains is that I would need to hold $25,000 in purchased stock for 1 year, thereby increasing my money invested. I want you to maximize profits without having to fork over the maximum yearly contribution of $25,000. At this time in my life, this is cash that I do not want to part with. The primary goal of this blog is to share how you can max your ESPP and maximize the earnings, something not many people do.
In my post About my Process, I explain how to maximize the ESPP by rolling/reinvesting $8,000 3 times or $6,000 4 times throughout the year. Then by selling call options, I can double my earnings. I have been doing this for a couple of years now and found I am most comfortable using 2 groups of $8,000 with overlapping timeframes.
I used an online capital gains calculator to estimate that I will owe a whopping $1,350 in STCG vs. $830 in would-be LTCG if I held and sold after 1 year. By waiting I could save $520 in taxes. (These numbers include $230 of state taxes)
Here is the calculation if I held the entire $25,000 for 1 year, then sold. And let’s take out the option premiums, because we are completely changing our investing strategy at this point to maximize for tax efficiency.
$2,500 (average profit from 10% gain on ESPP stock) – $830 (LTCG tax) = $1,670
$1,670 / $25,000 (total investment) = 6.7% gain
(Calculation does not include dividends, nor STCG tax on dividends)
I have simplified the calculations below by using an investment of $16,000 with a sale price of $20,000 to measure the STCG tax on $4,000 (actual yearly profits based on records is as high as $4,457). Also, all of the gains are short-term, while if I held the stock for 1 year, I would not have options premiums, and dividend income would still be taxed at the short-term capital gains rate.
$4,000 – $1,350 = $2,650
$2,650 / $16,000 = 16.5%gain
I am very happy with a 16.5% annual gain!
As you can see in this chart, your investment amount goes up, and profit, taxes, and total return (including taxes) all go down.
How to decrease your tax burden – decrease your taxable income.
- Use the proceeds from your ESPP to fund your Traditional IRA
- Donate your stock directly to charity instead of selling
The Option to Sell 