If you work for a publicly-traded company (and sometimes private ones too), you may have received restricted stock units (RSUs) as part of your stock compensation. If your RSU compensation is significant, it can often lead to unexpectedly large bills at tax time. This article explores the taxation of RSUs, the problem with RSU tax withholding, and why additional estimated tax payments are often required.
RSUs represent a promise to give you company shares when some future vesting event is satisfied. This vesting event is most often tied to continued employment. For example, a grant of 80,000 RSUs vesting quarterly over four years would mean that you earn 5,000 shares for every three months of employment with the company. On each vesting date, the shares that vest become unrestricted and can be sold on the open market (for publicly traded stock). Before the shares vest, they are restricted in the sense that you don’t actually own them and can’t sell them. If you leave before the four-year vesting period is complete, you will forfeit any unvested shares. Occasionally, RSUs may also have other requirements to vest such as a company IPO or the company hitting specific performance targets.
Taxation of RSUs
The taxation of RSUs is best explained through an example.
Grant date—The grant date is the date on which you are first awarded the RSU grant. Let’s use 1/1/2022 in our example. Taxes are super easy here. There is no tax impact on the date of grant.
Vesting date—Lets continue with our example of 80,000 shares vesting quarterly over four years. 5,000 shares would vest on 4/1/22 (the first vesting date), 7/1/22, 10/1/22, 1/1/23, 4/1/23, and so on… On each vesting date, the value of the stock that vests is taxed as wage income.
- On 4/1/22, the stock price is $20, thus the values of the shares that vest is $20 x 5,000 shares = $100,000. This $100,000 will be treated as wage income and taxed at ordinary income rates. Your company will usually automatically sell some shares for tax withholding and only release to you the after-tax shares. (The amount of tax withholding is often insufficient, but more on that in the next section). This $100,000 is also the tax basis for when you sell the shares later.
- On 7/1/22, the stock price has increased to $25, the value of the 5,000 shares that vested on this date is worth $125,000. Thus, $125,000 is the amount of wage income and also the tax basis for this second lot of 5,000 shares.
- As you can see above, the value of your RSU fluctuates based on the stock price at each vesting date. Thus, the amount of wage income you recognize is directly dependent on the stock price on each vesting date.
Sale date—on 8/1/22, with the stock at $23, you decide to sell 1,000 shares from the 4/1 vesting and 1,000 shares from the 7/1 vesting. It is usually a good idea to sell RSUs soon after they vest to reduce your concentration risk to a single stock, especially when you also depend on the same company for your salary.
- For the 1,000 shares from the 4/1 vesting, you realize a short-term capital gain of $3 per share or $3,000 total. This is calculated from the $23 sales price and the $20 tax basis.
- For the 1,000 shares from the 7/1 vesting, you realize a short-term capital loss of $2 per share (the difference between $23 sales price and $25 tax basis).
- The gains / losses would be long-term if you hold the shares for more than a year after vesting.
- In summary, the holding period for stock from RSUs begins on the date of vesting and the tax basis is the value of the stock at vesting.
Tax Withholding for RSUs
Because income from RSU vesting is taxed as wage income, it is subject to tax withholding for social security, Medicare, federal, and state income taxes. Often, the withholding rates on federal and state income taxes are inadequate and can lead to large tax bills. This is because the federal withholding for RSU income (which is treated as supplemental wage income) is done at 22%, which is well below the highest marginal tax bracket of 37%. For higher income households or for large RSU income, 22% can be far too little withheld. The same issue can occur at the state level though the exact withholding rates vary by state.
Let us look at another example to drive this point home. We will assume a high-earning couple is in the highest 37% marginal tax bracket and has an additional $500,000 of RSU vesting income. The additional $500,000 of RSU income will have tax withheld at 22%. This creates a problem as the couple will owe taxes of 37% x $500,000 = $185,000 but only withhold 22% x $400,000 = $110,000. The couple will have under withheld by 15% or $75,000. This will translate into a big tax bill in April and potentially penalties and interest if safe harbor withholding is not met and estimated taxes are not made.
I picked a 37% marginal tax bracket in the example above for a large contrast. It is important to note that insufficient withholding will occur anytime a household’s marginal tax bracket is above the 22% RSU withholding rate (which occurs when taxable income exceeds $89,075 for single and $178,150 for married filing jointly for 2022).
To also give a state income tax example, let us use California. RSU income is withheld at a rate of 10.23% in California. The highest marginal tax bracket in California is 13.3% (after factoring the 1% mental health tax on incomes above $1 million). Thus, automated withholding could be under withholding by up to 3% in California. On $500,000 of RSU income, that could be roughly another $15,000 owed at the state level.
Under withholding of RSUs could lead to a painfully large tax bill in April that is in the tens or even hundreds of thousands of dollars and perhaps trigger additional penalties and interest. At Think Different Wealth Advisors, we help clients avoid this by building out RSU vesting schedules and doing detailed tax projections using Holistiplan tax software to arrive at accurate estimated tax payments. Individuals with significant RSU vesting income should consult with their tax or financial advisor to do an income tax projection each year of their true tax liability and make estimated tax payments accordingly.