Equity compensation can be one of the most rewarding benefits employees receive, especially when it comes to Restricted Stock Units (RSUs). However, as with the possibility of any financial windfall, the benefits of RSUs can come with hidden complexities. One of the most common and frustrating challenges is unexpected tax bills after RSUs vest, catching many people off guard when they realize their taxes weren’t fully covered.
This situation, which I call the “RSU tax withholding conundrum,” can create financial stress and cash flow issues, especially if you’re already counting on that income. The following blog will dive into the ins and outs of this issue, provide real-life examples, and offer strategies to ensure you don’t fall into the same trap. For a beginner’s guide on RSUs, check out the Understanding Your RSUs blog as the following takes a deeper dive into the tax withholding challenges unique to RSUs.
What is RSU Tax Withholding Conundrum?
To start, let’s lay out a clear definition of the tax withholding conundrum: The RSU tax withholding conundrum occurs when the default tax withholding at vesting is too low, leaving individuals with a larger-than-expected tax bill. This happens because RSUs often push people into higher tax brackets, and the initial withholding doesn’t cover the actual tax owed, potentially leading to penalties and cash flow issues if not properly managed.
Why The RSU Tax Withholding Conundrum Matters
The RSU tax withholding conundrum matters because it can lead to unexpected tax bills and financial stress if not properly addressed. When your RSUs vest, this is considered a taxable event for income tax purposes. The taxable amount is calculated by multiplying the number of shares vesting by the stock’s closing price on the day of vesting. This amount is then added to your taxable income. During this event, tax withholding takes place, and depending on the method used (sell-to-cover or withhold-to-cover), cash is set aside to cover the tax withholding.
However, the statutory withholding rate is only 22% for supplemental income under $1 million and 37% for amounts above that threshold. The problem arises when the RSU income pushes you into a higher marginal tax bracket. This means the default 22% withholding may not cover your actual tax liability, leaving you with a significant shortfall.
If the withholding is insufficient, individuals may face penalties for underpayment, disrupt their cash flow, or be forced to sell shares during a trading blackout or at a less-than-ideal time. Without proactive planning, this conundrum can create a serious financial burden.
An RSU Tax Withholding Conundrum Example
Let’s create a hypothetical scenario for someone named Ethan. Let’s make up some basic facts about Ethan and his earnings as a senior software engineer. He has a base salary, bonus opportunities and multiple RSU grants that he’s accumulated over the years.
- Base Salary: $180,000
- Discretionary Bonus: $22,500
- Total Income: $202,500
For the purposes of this example and general simplicity, Ethan is single with no kids, and he does not contribute to his pre-tax 401(k), Health Savings Account, Flexible Spending Account, or any other employee benefits that would reduce his taxable income. He also does not itemize deductions and utilizes the standard deduction.
Before seeing the impact on the RSU tax withholding conundrum on Ethan, let’s review the federal tax bracket for an individual filing single for 2025.
| 2025 Tax Rates for Single Tax Payers (other than surviving spouses and heads of households) | ||||
|---|---|---|---|---|
| If Taxable Income Is | Then the Gross Tax Payable Is: | |||
| Over | But Not Over | Amount | Plus (percent) | Of the Amount Over |
| $0 | $11,925 | --------- 10% of taxable income --------- | ||
| $11,925 | $48,475 | $1,193 | 12% | $11,925 |
| $48,475 | $103,350 | $5,579 | 22% | $48,475 |
| $103,350 | $197,300 | $17,651 | 24% | $103,350 |
| $197,300 | $250,525 | $40,199 | 32% | $197,300 |
| $250,525 | $626,350 | $57,231 | 35% | $250,525 |
| $626,350 | -- | $188,769.75 | 37% | $609,350 |
Tax rate information compiled by the faculty of the College for Financial Planning.
Since Ethan makes $202,500, he will be in the 24% marginal tax bracket. This is without adding any of his RSU income.
Now, let’s assume that Ethan had an additional $100,000 of RSUs that vested over the course of the year. With this additional income, his new income is $302,500, which pushes him into the 35% marginal tax bracket. As you can see, RSU income can move you to different tax brackets rather quickly. This, among many other reasons, is why RSUs are often referred to as golden handcuffs. Your shares vest, and, based on the price at vesting, it gets added to your income. You don’t have much control here. This income should be seen as positive, but that feeling can quickly fade when you realize the new tax bracket you might be entering.
Looking further at Ethan’s tax withholding conundrum, he now finds himself in the 35% marginal tax bracket. However, his $100,000 of RSUs only had 22% withheld at the time of vesting. This means that $22,000 was withheld at the federal level, however he was already in the 24% marginal tax bracket and that RSU income could be taxed at 24%, 32% and 35%. The amount that would be owed requires more in-depth analysis, but the overarching story is that not enough tax was withheld relative to the income that was realized.
As if the additional tax bill wasn’t enough, Ethan could also face penalties for underpayment if he doesn’t withhold enough throughout the year. The IRS imposes penalties when taxes are underpaid, but the safe-harbor rule provides some protection. This rule states that if you pay at least 90% of your current year’s tax liability or 100% of your previous year’s tax liability (whichever is lower), you can avoid penalties. However, failing to meet these thresholds can trigger penalties, compounding the financial strain of unexpected taxes from RSU vesting. This makes careful planning even more essential.
How to Avoid the RSU Withholding Conundrum
As you can see from Ethan’s situation, RSU income can quickly move you into a higher tax bracket, leaving you with more taxes owed than initially withheld. This is a common trap for many equity compensation recipients, where the default withholding rate falls short of covering the actual tax liability. The under withholding could catch anyone off guard, and without proper planning, it’s easy to find yourself facing penalties for underpayment or scrambling to generate liquidity.
To avoid these financial surprises, proactive tax planning is essential. Without it, the benefits of equity compensation could be undermined, potentially derailing your long-term financial goals. Fortunately, there are several strategies you can implement to avoid this conundrum and ensure your RSUs work for you, not against you:
- Estimate Your True Tax Liability: Work with a financial advisor or tax professional to calculate your expected total tax based on your full income, including RSU vesting.
- Adjust Withholdings: Increase your tax withholding or make estimated tax payments to cover any shortfall from the default withholding rate.
- Plan for Cash Flow: Ensure you have enough liquidity to cover any additional taxes owed, especially if you’re in a trading blackout and can’t sell shares.
- Monitor Vesting Schedules: Stay aware of when your RSUs will vest, so you can plan for the potential tax impact ahead of time.
- Consult a Financial Advisor: Partnering with an advisor, like TCI Wealth Advisors, can help you integrate RSU planning into your overall financial strategy and avoid surprising tax bills.
Understanding these steps can make all the difference in managing your RSU taxation effectively.
RSU Tax Withholding Conundrum Key Takeaways
- RSU Vesting is a Taxable Event: When your RSUs vest, the value of the shares becomes part of your taxable income, which may push you into a higher tax bracket, increasing your overall tax liability.
- Default Withholding May Be Insufficient: The statutory withholding rate for RSUs under $1 million is typically 22%, which often falls short if the RSU income pushes you into a higher tax bracket. This can lead to significant under withholding for your taxes.
- Plan for Potential Shortfalls: Failing to adjust your withholding or make estimated tax payments can result in not only an additional tax bill but also IRS penalties for underpayment. Ensure you plan ahead to avoid these financial surprises.
Like many things surrounding equity compensation, there are a lot of nuances and Restricted Stock Units are no outlier. The illustration used in this example is one that we commonly come across and unfortunately it catches a lot of people by surprise. Paying additional tax when you know it is coming is one thing, however paying additional tax when you were not planning for it, is even worse! Not only is the additional tax painful, but what if you do not have the liquidity to pay it? What if you are currently in a trading blackout and cant sell additional shares? What if the only shares you can sell have short term capital gains and now you are creating a taxable event to pay tax.
With a TCI Advisor overseeing your financial journey, you navigate through RSU tax withholding conundrum and not be caught off guard by tax events like this. By taking a proactive, holistic approach to your financial strategy, TCI can help you set aside the right amount for taxes, avoid unnecessary penalties, and ensure that your equity compensation is aligned with your long-term wealth goals.
This material has been prepared for informational purposes only and is not intended to provide or to be relied upon as tax advice. TCI is neither a law firm, nor a certified public accounting firm, and no portion of its services should be construed as legal or accounting advice. TCI does not prepare or file tax returns for its clients. At all times, you should defer to the advice of your tax preparation professional. No client or prospective client should assume that any information contained herein serves as the receipt of, or a substitute for, personalized advice from TCI, or from any other investment professional.
