Your RSUs Are a Tax Time Bomb: Here's How to Defuse It

RSUs trigger taxable income at vesting, often creating unexpected liabilities. Proactive planning helps optimize withholding rates and minimize long-term exposure.

For many of you, tax season might bring a shocker, especially if you've recently joined a tech company and are receiving a large portion of your income from Restricted Stock Units (RSUs) or equity vesting. Trust me, I’ve been there myself! I still remember the first time I filed taxes after joining FAANG, only to be hit with a hefty, five-figure amount owed to the IRS. It was a huge wake-up call, and I don’t want you to go through the same stressful experience without knowing why it happens and how to avoid it in the future.

Why Did This Happen?

1. I had a significant portion of your W-2 income coming from RSU vestings.

2. I underestimated my and my spouse’s monthly income on the W-4 form, which necessitated an update to reflect both of our incomes.

First and foremost, it’s important to note that all W2 income is essentially taxed the same, regardless of whether it originates from base, bonus, or equity vests. However, the withholding rates can vary. The base and bonus amounts are influenced by the information you provide in your W4 form. On the other hand, equity vests may receive a completely different treatment. When your RSUs vest (usually at the scheduled date or a milestone), they’re treated as ordinary income and taxed at your regular income tax rate. This means the IRS considers the value of the vested shares as part of your W2 income, potentially pushing you into a higher tax bracket. Many new employees underestimate the amount that will be deducted, especially since they’re accustomed to seeing their paycheck appear relatively smaller after tax, without factoring in the impact of equity vesting.

Here’s what’s likely going on:

• The RSU Vesting Process: As your RSUs vest, they get converted into actual shares of company stock. The value of those shares at the time of vesting gets added to your taxable income for the year. This is not just some little side income; this can be tens of thousands of dollars or more, depending on your equity compensation package.

• Withholding May Not Be Enough: Companies typically withhold a portion of the RSU vesting value for federal and state income taxes, but often, the withholding rate they use is much lower than your actual tax rate. For example, the withholding rate might be around 22% (which is the flat rate for supplemental income), but if your total taxable income puts you in a higher bracket, you could owe more.

• Unexpected Tax Bracket Surprises: If the RSU vesting pushes you into a higher tax bracket, you could end up owing more than you expect when you file your taxes. Suddenly, that larger-than-usual paycheck feels like it was a bit of a trap.

How to Avoid This in the Future (or at least minimize It)

Now that you understand why you might be in for a surprise, let’s talk about how you can manage your taxes more effectively in the future.

Tax Planning with Your Equity Compensation

• Start by understanding how RSU vesting works and how it will impact your taxable income. Try to estimate how much tax you'll owe after your RSUs vest. You can use an online tax calculator to help estimate the the total taxes you will owe by including your RSU income.

Increase Your Withholding on W2 Income:

• You can adjust your tax withholding to account for the extra income that will come from RSU vesting. By doing this, you can have more withheld from your regular salary to avoid a large bill come tax time. You can use an online tax calculator or consult with a tax professional to help you anticipate this.

Max Out Tax-Advantaged Accounts:

• Take full advantage of tax-advantaged accounts like your 401(k) and HSA. These accounts can help reduce your taxable income and lower your tax bill, particularly in high-income years. You might want to consider contributing as much as possible to these accounts to offset the impact of the RSUs on your taxable income. I have covered in depth on how to maximize this in post before.

Consider Quarterly Estimated Tax Payments:

• If your RSUs vest in large amounts, it may be a good idea to pay quarterly estimated tax payments to the IRS. This way, you won’t have to worry about the surprise bill when you file taxes. These payments can help smooth out the tax burden and keep you from facing penalties for underpayment.

Example

Let’s go through a real world example. Sameer earns $380,000 (including $180,000 in RSUs) along with his spouse who earns $100,000. The couple were hit with whopping $35,000 additional tax bill from IRS in 2023. We will understand how they can adjust their withholding to avoid another large IRS surprise in the following year. Here’s the breakdown of their salary data and tax situation.

Why Did They Owe Extra Taxes?

1. RSU Withholding Was Too Low: In 2023, Sameer had $180,000 in RSUs vesting. The RSUs were subject to withholding at the 22% flat rate, but given their total income, they were actually in the 32% federal tax bracket. RSUs are automatically withheld at 22%, but for high earners, their actual marginal tax rate can be 32-35%, leading to a shortfall.

2. Under-Estimated W-4 Withholding: Spouse salary withholding was not enough to cover the full tax liability of the household.

Actions Taken to Avoid the IRS Surprise in 2024

To ensure they don't owe a large sum next tax season, the couple made proactive adjustments to their withholding:

1. Increased RSU Withholding to 32%:

   • Instead of relying on the default 22% withholding, Spouse 1 manually set aside an additional 10% of RSU income for taxes.

2. Updated W-4 Withholding for Both Spouses:

   • Sameer added an additional $18,000 in withholding from their base salary. ($1500/month)

   • Spouse increased their paycheck withholding by $6,000 ($500/month)

3. Maxed Out Pre-Tax Contributions Again:

   • Continued to max out 401(k) contributions ($23,000 each) and HSA contributions ($7,750 total) to lower taxable income.

Conclusion & Key Takeaways:

• ✅ RSU Tax Withholding: RSUs are taxed as regular income, so it’s crucial to adjust your withholding rate accordingly. In this case, Sameer’s RSUs should have been withheld at the 32% rate instead of the standard 22%.

• ✅ Update W-4 for Both Spouses: Ensure that both spouses update their W-4 forms to request additional withholding if needed, to cover any gaps in withholding for income from RSUs or other sources.

• ✅ Use Pre-Tax Accounts: Maximizing 401(k) and HSA contributions helped reduce taxable income.

• ✅ Plan for the Future: If you receive RSUs or other forms of equity compensation, make it a habit to plan ahead for taxes and adjust your withholding as needed. This will help avoid unpleasant surprises and give you a clearer picture of your tax obligations throughout the year.

Investment Disclaimer: The information presented here is for educational purposes only and does not constitute financial, investment, tax, or professional advice. Investments come with inherent risks and are not guaranteed; errors in data may occur. Past performance, including backtest results, does not guarantee future results. Please be aware that indexes serve as benchmarks and are not directly investable. All examples presented are purely hypothetical. Conduct your own thorough research and seek professional advice before making any investment decisions.