Every year, I get new clients who are surprised they still owe a significant amount in taxes on April 15, especially when they’ve set their tax withholding allowances to 0 (before the 2020 W4 update). Those same clients thought they would have enough taxes withheld by making that election alone. Unfortunately, because of their compensation structure, that’s not the case.
The common contributing factors those clients have are:
- They have a high annual income (more than $250k), and
- A lot of that income is in the form of restricted stock unit (RSU) grants or large bonuses.
If that sounds like you, keep reading. We’ll dive into some potential reasons why your tax withholding could be low and how to check on your RSU tax withholding for the year. But first, a brief review on restricted stock unit taxation.
How are RSUs Taxed?
RSUs generate taxes at a couple of different milestones: once when you take ownership of the shares (usually when they vest) and again (in another way) when you actually sell the shares.
Taxes at RSU Vesting – When You Take Ownership of Stock Grants
When your restricted stock units vest and you actually take ownership of the shares (two dates that almost always coincide), the value of the stock at that vesting date gets included in your income for the year as compensation. You will owe income tax (both federal and state, if applicable) as well as Social Security and Medicare tax on that amount.
Consequently, because you’re required to pay tax on the value of the stock at vesting and the IRS tries to avoid taxing you twice on the same income, that value becomes your RSU cost basis for when you sell the stock (either immediately or at a later date).
Taxes When You Sell RSUs
There is a separate capital gains tax that you’ll owe when you actually sell the stock award too, assuming you sell at a gain. The amount will be based on:
- Any appreciation over the RSU cost basis (sales price – market value at vesting), and
- How long you held the stock before selling (to determine whether you’ll have to pay short-term or long-term capital gains rates)
RSUs can be sold as a capital loss too. ????: losses on RSUs might help to offset other capital gains you’ve incurred during the year or up to $3k of ordinary income. (Side note: if you have capital losses, whether from RSUs or not, you should be taking advantage of this every year!) Just be sure to steer clear of any wash sale violations, especially if you have RSUs that vest frequently (monthly vestings being the most dangerous).
RSU Tax Rate vs. RSU Withholding Rate – A Common Confusion
It’s important to remember that the RSU tax rate will be the same as your income tax rates. This is true whether we’re talking about:
- The ordinary earned income tax rate when the RSUs vest, or
- The capital gains tax rate when you sell the shares you own
The withholding rate is what might be different, which is a common source of confusion. This is because RSUs, stock grants, and bonuses are treated as supplemental income and are often (but not always) withheld differently than your salary.
Why Your RSU Tax Withholding Might Make Your Total Withholding Too Low
Some companies do a good job of withholding enough on RSUs and bonuses throughout the year. They do that by either withholding supplemental income according to your W4 or by allowing you to specify how you want your supplemental income withheld (more difficult for the employer, but much more convenient for the employee).
If you work at one of those companies, be sure to fill out the supplemental income withholding form!
Many employers, though, make it far less convenient for the employee by withholding on supplemental income (like RSUs and bonuses) at a flat rate, which includes:
- 22% for federal taxes (37% if total income is more than $1million),
- Social Security and Medicare, and
- Some amount for state income taxes, if you live in a state that has an income tax. Here in CA, that flat withholding rate is 10.23%
“Why is this a problem?”, You Might Ask
Early in the year, when you’ve made less in cumulative income, the flat withholding rate will probably suffice, and you’ll look like you’re on track to be properly withheld for the year. As the year progresses, though, and you have more and more taxable income, your marginal tax bracket will be higher than what your employer is withholding on stock grants (RSUs) and bonuses, so it won’t be enough.
This results in a little bit of work on your end to make sure you 1) don’t have a large tax bill in April, and 2) aren’t getting hit with an underpayment penalty.
You’ll want to:
- Calculate how much should have been withheld, and
- Make estimated tax payments in the amount of the difference
RSU Tax Calculation – Here’s How to Check
There’s a fairly easy way to check how much more you should’ve had withheld on your RSUs at vesting. Here’s how:
The Back-of-the-napkin RSU Estimated Tax Calculation
Take a look at your year-to-date taxable income from all sources. For compensation income, this can be found on your most recent paystub (ideally the one that includes the RSU stock you now own). If you’re married and filing jointly, you’ll want to account for your spouse’s income too, as well as any other form of income for the year, such as:
- Income from another job,
- Business income,
- Rental property income, and
- Dividends, interest, and capital gains you’ve already received, to name a few.
- See where your year to date income falls within the IRS income tax brackets, and note the tax rate for your current marginal bracket. (Note: as you make more money throughout the year, your marginal bracket will increase, so I would recommend checking back in on the brackets each time you do this calculation.)
- Multiply the tax rate from #2 by the gross value of the RSUs that vested and subtract the amount that was already withheld by your employer.
- If you live in a state where you need to pay state income taxes, repeat steps 2 and 3 using your state marginal tax rate.
This calculation should give you a good back-of-the-napkin amount to pay in estimated taxes for your RSUs as they vest each quarter.
The In-depth RSU Estimated Tax Calculation
If you want an in-depth analysis of your income tax situation for this year (which includes more than just how much to pay on the RSUs), you’ll need to run tax projections. This will include simulating the current year’s tax return by:
- Making projections on what your W2 (or W2s – if you’re married and your spouse works or if you have multiple) will look like from your pay stubs,
- Estimating the value of RSUs that haven’t vested yet but will before the year ends,
- Estimating interest, dividends, and capital gains for the year,
- Estimating net business or rental income, if applicable,
- Estimating the amount of your annual bonus, if you get one,
- Estimating any other income subject to tax,
- As well as estimating total withholding on the above.
While it is possible to do them on your own (see this forecast spreadsheet), projections are best run with a tax professional and tax planning software to avoid errors.
Also note, I’ve included the word “estimating” a lot here to emphasize that you’re making a best guess at future income for the year, instead of only being backward-looking, like you would be under the back-of-the-napkin method. Obviously, there’s a lot that could change throughout the year, the most notable here being the stock price of your RSUs.
So, which method should you choose?
There’s no right or wrong answer here. The fact that you’re looking at this at all before the tax deadline will put you ahead of most people.
For the majority of people who get paid with RSUs, the back-of-the-napkin calculation should be enough to get you close to the actual taxes that you owe.
Full income & tax projections are helpful if you want to do any major planning for the year. They simply give you more information than the back-of-the-napkin approach. And since I do have access to professional tax planning software, my preference is to do them with LifeSighted planning clients. I always prefer to be forward-looking, when possible, rather than backward-looking.