The BITA household is a simple place as far as taxes are concerned. We are a pair of W-2 employees. We generate no income outside of our jobs. We own one house and we live in it. We receive some interest from our bank accounts, and some dividends from our investments. We purchase stock often and sell rarely. It is not uncommon for us to go an entire year with a sum total of zero sales of stock.
Yet somehow, in years past, we have filled out our forms at tax time and our eyebrows have shot clear up into our foreheads when we see what we owe. In a world of such overwhelming simplicity, how is it possible for us to ever get our estimated federal taxes wrong? How is it possible that we can ever be surprised by the federal income tax we owe?
The answer is RSUs or Restricted Stock Units. These babies are, from a taxation perspective, just a wee bit sneakier than you would expect. I’ll tell you how, and hopefully you can avoid any unpleasant surprises when tax time rolls around.
What Are RSUs?
RSUs are awesome. If you are fortunate enough to get your hands on some, pull on your grateful pants and do a happy dance.
RSUs are commonly part of one’s compensation package as a software developer in the Silicon Valley. RSUs are one way for your employer to give you company shares. They are subject to a vesting schedule determined by your employer.
An example of an RSU grant is the easiest way to understand the concept.
|Jan 2013||Grant date. You are awarded 1000 RSUs that will vest over 4 years.||At this point you own 0 shares of your company. If you quit before the stocks vest, you get nothing.|
|Jan 2014||First vesting date. 250 RSUs vest today. The company stock price is $40.||At this point you own 250 shares, and your stock is worth $10,000. If you quit now you get to keep the 250 shares, but have to wave bye-bye to the remaining 750.|
|Jan 2015||Second vesting date. 250 RSUs vest today. The company stock price is now $45.||You now own 500 shares, and your stock is worth $22,500.|
|Jan 2016||Third vesting date. 250 RSUs vest today. The company had a bad year and the stock price is now $39.||You now own 750 shares and your stock is worth $29,250.|
|Jan 2017||Final vesting date. The last 250 RSUs vest today. The stock price is now $47.||You own 1000 shares and your stock is worth $47,000.|
This example should make it clear why RSUs are frequently referred to as golden handcuffs. I’ve kept the example pretty simple, but in real life, you will typically get additional RSU grants every year based on your performance and the performance of your company. This means that you will have multiple overlapping vesting schedules and there is no point in time where you can look down at your wrists and find them shackle-free. To continue with the example above, if you were granted an additional 500 RSUs in Jan 2015 with the same vesting schedule as the first grant, then in Jan 2017 when your first grant runs out, you will still have 125 outstanding RSUs from the second grant that you won’t get your hands on till Jan 2018.
The other thing to note here is that RSUs are almost always worth something. Unless your share price drops to $0, the grant will always be worth some money.
Taxation of RSUs
You pay no taxes when an RSU is granted to you. The vesting of an RSU is a taxable event.
In the example above, the vesting of 250 shares that occurred in Jan 2014 would be a taxable event. The market value of the stock on the day that the stock vests is treated as income, and will be taxed at your marginal income tax rate. In this example that would mean that you have an additional $10,000 of taxable income in 2014. You will also owe FICA taxes on this income, as well as any state and local income taxes.
Sounds simple so far doesn’t it?
This income is subject to mandatory withholding. The typical way in which most companies (including mine and Mr. BITA’s) deal with RSU taxation is called sell to cover. The employer sells just enough of the vested shares to cover the withholding and you get to keep the remaining RSUs to sell whenever you see fit.
Continuing with our example, in Jan 2014 when 250 RSUs vest the company might sell to cover 100 RSUs, and you will actually receive 150 RSUs post-tax.
The employer includes the total value of the vested RSUs ($10,000 in our example) in Box 1 of your W2, and the withholding is also reflected in your W2.
With me so far?
Do you see why I used to be baffled that I ended up owing federal taxes? My company had taxed me when the RSUs vested and they reported the income and withholding on my W2. What was going wrong?
The Fine Print of RSU taxation
Here is the catch: RSU income is supplemental income. While the amount of tax withheld from your ‘regular’ income (a.k.a your paycheck) is based on data you provided when you filled your W-4 form, supplemental income may be treated differently by the company.
A company could choose to combine this income with your regular income and have it all be taxed together. This isn’t common though. Instead, companies almost always withhold the required minimum amount for federal supplemental income tax: 25% for federal taxes and 35% for total yearly amounts over $1 million.
This means that if your marginal tax rate is > 25% and you aren’t vesting stock worth more than a million dollars, you did not pay enough income tax when your RSUs vested. If, for example, your marginal tax rate is 30%, you will owe 5% on the market value of your vested RSUs when tax time rolls around, and maybe even a penalty for not paying what you owed on time.
Thankfully, the remedy is simple. If your marginal tax rate is x%, and if x > 25, then every time your RSUs vest, do this math:
Taxes owed = (x% – 25%) * market value of RSUs on vesting date
Pay that amount as estimated taxes to the IRS, and enjoy your April free of unpleasant surprises.
A Final Note
While I’ve focussed on RSUs in this article, bonuses and awards typically suffer the same fate as RSUs. So when your employer showers you with a little extra cash, remember to put aside what you owe Uncle Sam before you go bathe in your good fortune.