Avoid A Huge Surprise Tax Bill With This RSU Planning Strategy…
WRITTEN BY: Gideon Drucker, CFP® AIF® ECA
Restricted Stock Units are a wonderful thing.
Most of our clients at the larger tech companies (Amazon, Meta, Adobe, Microsoft) are granted Restricted Stock Units as part of their compensation.
Over the years, we’ve spent a good amount of time explaining how RSU’s work, and how you should start thinking about your company stock (vested RSU’s) as part of your broader financial plan.
If, for some strange reason, you don’t want to re-read 2,000+ words on RSU’s on my blog I will summarize those points below:
Restricted Stock Unit grants allow you to receive shares of your company stock at a specified date in the future (as long as you are still employed on that future date). This “vesting date” is when you will actually receive those shares and see them deposited into your account. For example, if you received a grant of 2,000 shares of Amazon stock on August 1st 2021 and the first 500 shares of stock vest on August 1 2022, than you would have received those 500 shares this past Monday.
The tax treatment of your vested RSUs is identical to your regular compensation (W2) income.
This means that you are responsible for paying ordinary income tax on the value of those shares on the day that they vest. So, to use the same example, if 500 RSU’s vested this past Monday, and the price at that time was $135 per share...then you just added $67,500 to your taxable income for the year. (How I got there: $135 x 500 shares = $67,500).
This is the key from a tax standpoint: What you choose to do with the stock after Monday’s vest HAS NOTHING TO DO WITH THIS TAX LIABILITY. You are responsible for paying taxes on that income regardless of whether you chose to sell or hold onto the shares.
As an aside, this means that there is absolutely no tax reason to hold onto Restricted Stock Units after they vest.
These are not like Incentive Stock Options (ISOs) in which it generally makes sense to hold onto the shares for one year to realize long term capital gains on the discount element of the option.
With RSUs you are paying ordinary income tax on the RSU’s when they vest… no matter what!
I always like explaining RSU’s in the following way: Let’s pretend that your company gave you a $67,500 cash bonus on Monday and then you decided to take that $67,500 and buy Amazon shares on the open market.
You are in the exact same position in that example as you would be if you had 500 RSU’s of Amazon stock vest on Monday instead. Either way, that $67,500 value that you received on Monday is taxable at ordinary income. Either way you now own 500 shares of Amazon stock outright. If you were to sell it on the same day (or close enough to it) there would be negligible capital gains/losses because the price wouldn’t have fluctuated from the purchase price/vesting price. (Alternatively, if you choose to hold onto the stock indefinitely, you will be responsible for paying capital gains on the distribution whenever you do sell.)
There’s a second reason that I pose this hypothetical to my clients: If your company gave you a $67,500 cash bonus, is there any universe that you would go out and take ALL OF THAT MONEY to buy one single stock? Of course not! Nobody would do that.
We would look to diversify that additional income between savings, investments, and retirement accounts and we would look to save that money into a broader and more diversified portfolio of equity investments, instead of betting the house on the fortunes of any one company!
The same logic should apply to your vested RSU’s!
Ok…let’s take it a step further and explain the most common way that people pay this tax liability as the shares vest: it’s called “sell to cover.”
Most people elect “sell to cover” when choosing how they want their vested RSU’s paid out. This means that if 500 shares vested this past Monday, you would receive 350 shares and the other 150 shares would be held back by the company to pay your tax liability up front.
People do this so that they are not hit with a gigantic tax bill come tax time.
To keep in line with our example, if 500 shares were vested on Monday, which means $67,500 shares of ordinary income coming your way….and you chose not to withhold any shares for taxes, you would realize the following April that you owe the government a lot more money.
Let’s use real numbers again. Let’s say your salary/bonus is $400,000 and you have the proper withholding taken out of both on your W2’s as they come in so that you don’t owe much time come tax time or get a refund (this is the best case scenario by the way!)….cool. But if you never paid taxes on those 500 shares as they vested, you would owe taxes on that additional $67,500 of ordinary income that was not included for the purposes of W2 withholding, and if you are in the 37% tax bracket, well…you can do the math!
Ok, so that’s why people “sell to cover”. You’re paying taxes on the shares as they vest so you’re not left with such a large one-off surprise tax bill later on! It’s the same reason why having taxes taken out of each paycheck saves a lot of hassle come tax time!
There’s one additional point to make note of because we see that clients come to us confused and frustrated that they STILL owe taxes even after selling to cover their RSU’s (and understandably so!) Here’s where the problem comes in: Restricted Stock units are typically withheld at the 22% federal level. If you are in the 28%, 32% or 37% tax bracket and your RSU’s are being taxed only at 22% withholding…well, then there’s going to be an under payment of tax throughout the year that will leave you with an unwanted tax liability come tax time!
So, what can be done to avoid a surprise tax bill?
It typically makes a lot of sense to set up quarterly estimates with your tax preparer. Once your CPA understands your withholding rate, extra income via RSU’s, filing status, retirement contributions etc. they would be able to figure out how much you might owe ON TOP OF your current payments and set up a program to pay that amount throughout the year proactively (Ie: paying the IRS an additional $5,000 per quarter so that you don’t owe anything come tax time.)
As a good rule of thumb, if you consistently owe the IRS money come tax time, and especially if you have RSU grants, it probably means you should be setting up quarterly estimates to eliminate any unwanted surprises. All Drucker Wealth clients are introduced to our chosen CPA firm to straighten this out (along with many other tax planning questions) to ensure that your tax planning & prep has the same level of intentionality and purpose that your financial & investment planning does with us!
This puts you in more control of your tax situation throughout the year. No surprise tax bills come April.
If you feel uncertain about your RSUs and tax situation, I welcome your thoughts and concerns...
You can schedule a 15 minute "Right Fit" call so we can figure out together if there's more you can be doing now in your financial world.