Many professionals and executives who receive Restricted Stock Units (RSUs) as part of their compensation package have come to me with a similar challenge…
“I get killed in taxes when I file my tax return. What can I do?’
Income from Restricted Stock Units can create a surprise tax bill if you haven't planned ahead. While there are a few strategies that can be implemented to reduce the tax impact of RSUs, the first step is to become what I call...tax–aware.
One of the first things I do with clients is to review their total estimated income and any upcoming RSUs that are vesting (this year and beyond). This allows us to proactively plan cash flows and understand what to expect well before tax time to be one step ahead of Uncle Sam.
To help you visualize and understand this, I'm going to walk you through a simple yet real-life example of how RSUs can create a larger-than-expected tax bill.
Using the same planning tools I use with my clients, let’s plug in some numbers for a married filing joint couple. Their total normal salary income is $450,000. (In this first scenario, we aren't including any RSU income, so you can only see the direct tax impact on salary income).
Once this income passes through the federal marginal tax brackets, the total tax is $91,829. One key point is that they're in the 32% marginal tax bracket, which is where each additional dollar of earned income is taxed.
However, the effective tax rate is just over 21%. This is the actual tax rate based on taxable income. Th effective rate is important to know when we bring in the RSU income.
The last step is to factor in how much federal tax is expected to be withheld from paychecks throughout the year. After reviewing both paystubs, we estimate their tax withholding will be about $90,000.
As far as estimates go, they are close enough to being on track for tax withholding!
Now, we bring their restricted stock units into the picture.
Before we dive in, let's quickly understand the taxes on RSUs.
When RSUs vest, it’s earned income on your paycheck. This means the amount vesting is subject to federal, state, Social Security, and Medicare taxes. Generally, the company will withhold taxes from your shares (they do this by selling some shares).
For federal tax, RSU income is withheld at 22% (and 37% for supplemental wage income over $1 million).
Now that we understand RSU tax withholding let's return to our example scenario. Let’s say this client just had 200,000 of RSUs vest. We update our tax estimate accordingly…
Now their total income is $650,000. But how much does it change taxes? Lets compare the two scenarios side by side...
Because we are adding income in the 32% bracket and also getting into the 35% tax bracket, you can see this increases the total tax from $91,829 to $161,630!
Since RSU income is only withheld at 22%, you can see where the tax withholding starts to struggle! In this case, we add $44,000 (22% of $200,000) to our tax withholding calculator. This gives us a total estimated withholding of $134,000 for the year.
With an estimated total tax of just over $161,000, and withholding of $134,000 from paychecks, we are left with an estimated $27,000 in taxes not accounted for in withholding!
The good news is that since we are proactive, this gives us time to plan and not scramble at tax time! This is where tax awareness is key. Now we know what to expect!
For many clients in a similar situation, we set up a separate savings account labeled “tax holding.” We then review all resources to determine a game plan to fund the tax account with about $27,000. We can do this in several ways.
The best part is that my clients are not getting this news on April 15 and trying to figure out where to get $27,000 from. Which usually results in being forced to sell stock at the wrong time.
Whether or not you have the financial resources to pay the additional taxes, it's not fun to have a surprise tax bill.
With any stock compensation, you need to do financial and tax planning throughout the year. This will not only create tax awareness but also set the stage for tax strategies.
If you are tired of figuring out your RSUs yourself or your current financial advisor isn't offering guidance in this area, reach out. We do this with clients every day.
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