Farther does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.
Restricted Stock Unit (RSU) owners (employees) often get an unpleasant surprise from the IRS when learning about their taxes due from their RSU redemptions. To avoid writing a big check on tax filing day it is important to understand how your redemptions are withheld and taxed.
Here’s some definitions to level set:
- Withholding - When your employer withholds funds to pay taxes upon exercising your RSUs.
- Tax Liability - Your actual tax bill, regardless of employer withheld amounts, when you file your tax return at the next year.
RSUs have risen in popularity ever since the Financial Accounting Standards Board issued a statement regarding stock options in 2004 requiring companies to book an accounting expense for incentive stock options (ISOs) issued. Since then, HR departments have increasingly incorporated RSUs into their overall equity-based incentive employee compensation plans.
How do RSUs work?
When you receive a RSU grant, you don’t actually receive the common stock granted. Instead you get a commitment to receive stock in the future based on the specified company vesting schedule. In some cases, this employer commitment can be paid in cash instead of stock.
When you redeem RSUs, you receive and recognize income and thus incur a tax liability when the shares are delivered. Specifically, you recognize the fair market value of the stock, or what the value of the shares are worth in total, on the date the shares are transferred to you. Your employer then withholds funds for future taxes due like they do for all of your employment income.
But RSUs are treated as supplemental income at most employers, which is usually withheld at a rate lower than your ordinary income withholding rate. Most employers withhold RSU income based on predetermined supplemental schedules at a flat rate of 22%.
The problem is that as a result of your RSU windfall, combined with your regular salary, your actual marginal tax rate, when paying taxes next year may be much higher than the supplemental withholding rate.
An example of the tax implications of RSUs
For example, if an employee received a 4,000 share RSU grant on a four-year vesting schedule in 2019 and the first year’s vesting became due this month in 2020, here’s how funds would be withheld and then ultimately taxed:
- Employee RSU redemption: In calendar year 2020 the employee redeems $100,000 ($100 share price * 1,000 shares) of their vested RSUs
- Employer Withholding: Upon redemption, the employer withholds $22,000 of the employee’s RSU income based on a supplemental withholding schedule (22% supplemental rate * $100,000 of the RSU income)
- Employee W2 received: In January 2021, when the employee’s W2 arrives she sees that the additional $100,000 RSU windfall falls entirely in the top marginal tax rate bracket (37%)
- Tax preparation time: When preparing taxes in 2021, her actual tax due from RSUs is = $37,000 (37% ordinary income tax rate * $100,000)
- Tax surprise - Since funds from her RSUs redemptions were withheld at the 22% supplemental rate she has to come up with an additional $15,000 out-of-pocket to pay her taxes due on April 15th.
What should you do when redeeming RSUs?
The bottom-line here is that taxpayers should be aware of this supplemental income vs. ordinary income withholding gap. Additional unexpected taxes due from RSU redemption piled on top of an existing tax liability can be painful.
When employees redeem RSUs they can take immediate action to avoid such a tax-day surprise by either:
- Adjusting their withholding amounts through their W-4 elections (check this form here), which is done through their employer, or
- Setting aside funds for taxes in their own separate savings or conservative investment account, and let the principal grow until the following year’s tax filing time.
Being proactive about managing your withholdings won’t reduce your taxes, but it can certainly help avoid surprises.
