A restricted stock unit, or RSU, is a type of compensation that a company provides to its employees instead of traditional wages like a salary or bonus. While an RSU gives you the right to receive stock in the company you work for, you are also required to satisfy any conditions imposed by your employer before those shares are transferred to you. This requirement is known as vesting. 

Behind the Scenes of RSUs

An RSU requires you to earn the shares. Until then, your RSUs are subject to a substantial risk of forfeiture. Meaning, if you leave the company before the RSUs vest, you will forfeit your right to them. A substantial risk of forfeiture is essentially a wonky tax term applied by the IRS. It helps determine whether deferred compensation and property transfers should be taxed in the current tax year.

Whether you decide to sell any of the shares you receive as part of your compensation or not, there can be complex tax rules governing your RSUs. Generally, the income you report when you receive the stock is considered compensation income, which means it is ordinary income, not a capital gain. However, when you sell those shares, any additional profit or loss is treated as a capital gain or loss. As a result, equity compensation can generate ordinary income, capital gain, or a little bit of both. This is especially true in the case of RSUs.

Equity Compensation is Income Too

Even if your income is paid in the form of company stock, the IRS expects to receive their share in dollars. And your employer has the obligation to collect this money from you as withholding and report it to the IRS on your behalf. The amount withheld must cover a significant portion of your estimated federal and state income taxes for the year. 

However, the amount withheld by your employer will not necessarily be substantial enough to cover the full amount of the taxes due on this income. The portion withheld is treated as a credit against the tax you owe and gets applied to your tab when you file your return at the end of the year. Therefore, it is important to consider the stock as income, and plan wisely for the corresponding tax obligation.

The Supplemental Wage Rate

Most companies will withhold taxes due on RSUs when they vest using the supplemental wage rate. This is the same rate that is used when an employee receives a cash bonus. When you receive RSUs, the fair market value of the shares is taxed as supplemental income at the federal supplemental wage rate of 22% in the year they vest.

That rate is applied to any supplemental wages (including bonuses) up to $1 million during the tax year. If your equity compensation and any cash bonus income total more than $1 million, then the withholding rate automatically increases to 37% on the next dollar above the $1 million mark.

When special income items such as equity compensation are withheld by your employer, you can end up owing significantly more than the tax amount that was withheld. That is due to the possible discrepancy between your marginal tax rate and the 22% supplemental wage rate. 

For example, if your ordinary income falls in the range where the last portion is taxed at 32%, you will have a deficit of 10% between the automatic withholding and your marginal tax rate. Keep in mind that this does not include any additional Medicare or state taxes you may also be responsible for.

There is No Such Thing as “Too Many Questions”

Many companies make it possible to sell some of the shares you receive at the time of vesting so that you don’t have to come up with money out of pocket to pay the withholding. Some employers even elect to have this happen automatically for every employee to avoid any discrepancies later on.

It may also be necessary to sell additional shares to cover the difference between the supplemental wage rate and your marginal tax rate. You can certainly pay this amount without selling any additional shares if you pull the money from other sources. 

However, this approach makes it possible to lose money on RSUs even after they have vested.

Let’s say your ordinary income fell in the range where the last portion was taxed at 32%. You would have a deficit of 10% between the automatic withholding rate and your marginal tax rate. If you decided to cover that 10% deficit at tax time out of pocket and the share price of your stock fell below its initial price at vesting, then you would own a stock worth less to you than it was on the day that it was vested. 

Consider the Stock as Income

For that reason alone, selling at least enough shares to cover any remaining taxes due immediately following each vesting period is advisable. If you don’t, and the fair market value of your shares declines, you will pay income taxes out of pocket for shares that are no longer worth what they were when you received them. 

Unfortunately, there are no do-overs when it comes to equity compensation planning; you have to get it right the first time. If you make a mistake managing your shares, it could be the difference between creating wealth and losing it. Thus, careful planning is essential to avoid any surprises come tax time.