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Commentary & Insights

Insight, Stock Options

Why RSUs Cause a Surprise Tax Bill

26 January 2023
surprise tax bill
Joe Ferreira, Sam Marshall, Jack Rabuck,

By: Joe Ferreira, Sam Marshall, Jack Rabuck

A person doesn’t know how much he has to be thankful for until he has to pay taxes on it.”

—Ann Landers

Another year has passed, and with the changing of the calendar comes America’s least favorite pastime: doing our taxes. Even those of us who farm this work out to a CPA still wait on pins and needles to find out if we paid enough throughout the year, or if we’re getting hit with a surprise tax bill that will wipe away the money we had saved for a vacation or some work around the house.

About 75% of Americans received a tax refund in 2021, and the average refund was $3,039. If you’re reading this article, you probably belong to the other 25%.

There is nothing special about getting a refund. It simply means you paid more taxes than you owed, and the government is giving you back your money. But it certainly stings to think (hope?) you’ve paid what you owe, only to find out you haven’t. 

How RSUs can cause a tax headache

A major culprit for this misalignment of expectations is Restricted Stock Units, or RSUs (which are occasionally referred to as PSUs). Why is this the case? Don’t shares get sold immediately upon vesting to cover taxes?

The answer is actually pretty simple: if your total income is less than $1 million, federal withholding for RSUs is typically done at a flat 22% rate. While this rate may be enough for certain taxpayers, it falls short for others.

If your total income in 2022 was below $178,150 for married filers ($89,075 for singles), then you should have nothing to worry about – the number of shares automatically sold for withholding was sufficient to pay the taxes owed when the shares vested.

If your income was higher than that, you may run into a problem since your marginal tax bracket will exceed the 22% being withheld. If your combined income is less than $340,100 ($170,050 for singles), which puts you in the tax bracket of 24%, it’s only a minor problem as are only 2% above the withholding amount. But if you’re at the top of the 24% bracket, you could end up owing more than $3,000!  If you only have income from your salaries, you might not even notice; perhaps other withholding might have been enough to offset the underpayment (remember the average refund was nearly this amount!).

This really becomes an issue for people making more than $340,100. Income above that is taxed at 32% federally, income above $431,900 is taxed at 35%, and the highest bracket, which is taxed at 37%, starts at $647,850 (interestingly for singles the 35% bracket is much wider, going all the way to $539,900 instead of the standard 50% of the married bracket).

How big is this problem?

If your combined salary/bonuses were $300,000 and you had $250,000 of RSUs vest, you could owe more than $25,000 (!) (assuming your other withholding was accurate).

When this happens, people usually get mad at their CPA (if they have one) or feel pressure to go find one if they don’t. Unfortunately, the CPA can’t do anything to lower your taxes. They could easily make the calculation for you, and tell you in advance what you will owe, but that would cost you some billable hours, something most people are hesitant to do.

Here is a visual that helps illustrate the issue:

RSU witholding chart

What should you do? 

We’re not going to wade into the debate about immediately selling your RSUs when they vest (there is more than one right answer), but we do think there is a tangible step you can take. 

If you think you fall in the 32% bracket (or want to be extra safe and have money just in case), our advice is to sell at least 10% more of your shares and hold that money aside for taxes. You could also earmark a similar amount from elsewhere if you think it makes more sense to keep your company stock. No need to do anything fancy or pay to have your CPA make estimates. 10% might be a bit too high or a bit too low depending on your income, but it should cover the bill for most people and avoid the headache. 

What you should not do:

The stock market is very volatile in the short-term (2022 reminded us all of that) and the price of the stock can go down, maybe even a lot, and you’re taxed on the value of the stock when it vests, regardless of what it does after that.

Last year we spoke with an employee of a company that was a major covid beneficiary and the price of the stock went WAY up, vesting at a very high price and generating a large amount of taxable income. This person did not sell any stock, or set aside money from elsewhere to cover the taxes, and by the time his tax bill came the price of the shares had cratered and the total value of the shares was not even enough to pay his taxes. 

This example may sound like an outlier, but it hammers home the risk of waiting until your file your taxes to sell additional shares.

What about state taxes?

Interestingly, California withholds at a high enough rate that you usually receive a refund, potentially offsetting the federal tax you owe. You should look at what tax bracket you fall into for the state you live in and compare that to what is withheld for you. All withholding information can be found on your pay stub.

We’re here to help if you have questions. RSUs are a great tool to build wealth; don’t let them become a headache.