If you’ve ever received a painful tax bill on April 15th and wondered what happened, this post is for you. RSU vesting hurts at tax time! You might have wondered at the time, “How can I possibly owe this much in taxes?”. After all, your company did withhold A Lot of taxes and you received a net amount of shares when they vested. What we’ll see is that A Lot of taxes isn’t always Enough taxes.

A Quick Lesson on RSU Withholding

Did you know that there are two entirely separate mechanisms for withholding for income? You’re probably familiar with filling out a W-4 withholding form for your employer during your first week of work. The W-4 form attempts to help you set the correct level of withholding. Unfortunately, it’s more complicated than it really has a right to be. And it’s hard to fill out even for tax professionals.

The W-4 form is what your employer uses to set your Federal withholding on your regular salary. However, if you receive bonuses, commissions or stock compensation like RSUs in a separate payment, the W-4 isn’t used. This is because the IRS has a special withholding rule for what it calls “supplemental compensation.” 

Supplemental compensation is defined in IRS Publication 15 as:

“Supplemental wages are wage payments to an employee that aren’t regular wages. They include, but aren’t limited to, bonuses, commissions, overtime pay, payments for accumulated sick leave, severance pay, awards, prizes, back pay, reported tips, retroactive pay increases, and payments for nondeductible moving expenses.”

In most cases, the IRS requires employers to use a flat 22% withholding rate on all supplemental compensation. However, if your salary and other compensation is over $1,000,000, then employers are required to withhold at an alternative 37% Federal rate.

Example 1

Here’s an example of how withholding might look for an employee receiving RSUs. Let’s assume a single taxpayer living in CA has a yearly wage of $150,000 and an RSU payout of about $10,000 per quarter.

Withholding on first quarterly RSU vesting:

Table 1 - Withholding on Q1 Vesting

As you can see, the total tax burden is about 40% when taking all payroll taxes into account. However, of this 40%, only 22% is allocated towards your Federal income tax withholding. The good news is that the 22% withholding isn’t that far off from the taxpayers actual withholding rate.

How Tax Brackets Work

When you go to file your tax return, your actual effective tax rate is determined by your total taxable income for the year. This includes your salary but also interest, dividends, capital gains and other income and deductions. Since your employer doesn’t have any knowledge of these items, your withholding is an estimate for the year.

Your final tax return liability is computed using the Federal tax rate schedule which is adjusted for inflation each year. Below are the 2023 tax brackets for a single taxpayer.

Table 2 - 2023 Federal tax bracket

After taking the standard deduction, our example taxpayer is going to likely be in the 24% tax bracket at year end. It’s important to note that your income flows through each of the lower brackets first which means you do get the advantage of the 10%-22% brackets in our example, even though the final dollars earned are taxed at 24%. For our example taxpayer, this is good news, and means they might not owe much at tax time. While the RSU withholding was likely under-withheld by about 2%, having the benefit of the lower tax brackets might be enough to generate a bit of a refund or a small balance due.

Example 2

Now, let’s look at what happens as your RSU vesting grows over time. Let’s assume the example taxpayer has been at their company for a few years and salary has increased to $240,000. In addition, there is now a 25% bonus potential as well as $100,000 of RSUs received, 25% each quarter.

Table 3 - Vesting Example 2

At first glance, this looks very similar to our first example with about 60% of the net value of the shares received.

However, from our table, the actual tax withholding on $400,000 of annual income for a single taxpayer is:

Table 4 - Withholding Tax Example 2

While our example taxpayer had 22% withholding on RSUs, the actual marginal tax rate would be 35%, a withholding shortfall of 13% or about $13,000 in our example (on $100,000 of RSU compensation).

This is a painful lesson at tax time, and a story we hear from many new clients when they prepare their first tax return after receiving their first RSU vesting. While there are plenty of other errors to make with stock compensation, this is by far the most common.

If you’re new to RSUs, now is a great time of year to estimate your tax liability. And if you need help, we’re here for you.

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