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Dangerous Options
By Karen Hube, May-June 2004
An archaic tax law might steal their life’s savings. Are you about to get walloped, too?
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Four months after he retired, Wolfgang Orst, 62, of Portland,
Oregon, got a note from his accountant saying: "Federal
taxes due: $95,000." At first he and his wife, Andrea, 59,
just laughed. After all, at his $42,000-a-year former salary and
her $38,000 income as a database analyst, it had to be a mistake.
But it wasn't long before they felt like weeping. The bill
was accurate.
Wolfgang, a former customer-service manager at a small technology
company, was one of millions of employees in the late 1990s who
were given stock options as a pat on the back (often in lieu of
cash raises). Everyone from mailroom clerks to top executives
were given these stock options, and all held promise that
they'd pay off.
Wolfgang was sure his had: just before he retired, he exercised
his right to buy incentive stock options valued at just over
$300,000 for a deep discount. (His option price was $1, while the
share price was $83.) The couple dreamed of buying a sailboat and
seeing the Caribbean. What they didn't realize is that when
you exercise incentive stock options you risk getting hit with
the alternative minimum tax (AMT), which was designed in the
1960s to prevent the superwealthy from avoiding taxes through
creative shelters.
The trouble is, the AMT hasn't been updated and is now
striking millions of decidedly unwealthy people. (You must pay
the AMT when your tax bill under the regular income-tax system is
less than your tax bill under the AMT system. When you exercise
options, your AMT bill is almost always bigger, because under the
AMT calculation you must count the spread between your exercise
price and the market share price as income.) With just $110,000
in their 401(k) and IRA, the Orsts are far from fat cats. Worse,
Wolfgang's company went bust soon after he retired, rendering
his stock worthless.
Strengths
The Orsts have $7,000 remaining on their $160,000 mortgage.
Andrea's employer provides their medical coverage. Wolfgang
wants to get another job, so they'll both continue working
until full Social Security retirement age, when they'll
collect monthly payments of $1,141 and $1,124,
respectively—covering their $2,000 monthly expenses.
Weaknesses
Declaring bankruptcy won't clear their debt. So the Orsts
could lose most of their savings to pay taxes on income they
never got.
The Plan
The Orsts must hire a tax attorney experienced in "offers in
compromise," which are pleas for a reduced tax bill.
"You have to follow specific procedures and use the lingo
the IRS wants to hear," says Matt McGrath, a certified
financial planner with Evensky, Brown & Katz in Coral Gables,
Florida.
The IRS is occasionally merciful to older taxpayers. If the Orsts
get the average settlement, they'll pay only 12 cents for
each dollar owed, or $11,400, says Jeffrey Kess, a tax attorney
in Atlanta. In that event, they should pay the bill in full, as
installment plans can add thousands in penalties and interest.
If the IRS demands that the Orsts pay the full AMT, it would cut
their $110,000 retirement nut to just $15,000. To prepare,
Wolfgang should try to find a job at his old salary level, which
would allow the couple to sock away up to $10,000 annually in an
investment portfolio of stocks and bonds. Even with a modest 5
percent annual return, they could accrue $60,000 or so by the
time Wolfgang turns 66—enough to cover emergencies. And to
pay for a cruise to celebrate their heroic comeback.
Karen Hube, our new money columnist, has written for The
Wall Street Journal. She lives in Westport, Connecticut.
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