Why your RSU withholding is not enough

If a meaningful part of your pay comes as RSUs, there is a good chance you are quietly under-paying the IRS all year and will find out in April. Nothing is broken and nobody made a mistake. The payroll rules themselves guarantee it. Here is how the gap builds and how to close it.

RSUs are taxed as ordinary wages

When RSUs vest, the market value of the shares that day is ordinary wage income. It lands on your W-2 next to your salary and is taxed at exactly the same rates. There is no capital gains treatment at vest, even if you never sell a share. Only the price movement after the vest date becomes a capital gain or loss later. So a $150,000 vest is taxed like a $150,000 raise, and it stacks on top of your salary in your highest bracket.

The flat 22% problem

Payroll systems treat vests as supplemental wages, the same category as bonuses. The IRS lets employers withhold federal tax on supplemental wages at a flat 22%, and nearly all of them do. The flat rate never looks at your salary. If your combined income puts the vest in the 32%, 35%, or 37% bracket, every vest is under-withheld by 10 to 15 points, by design. Only supplemental wages beyond $1 million in a year must be withheld at 37%.

Selling shares to cover taxes does not fix this. The standard sell-to-cover only sells enough to fund that same 22% withholding, so the shortfall remains.

How big the gap gets

Take a single filer with a $200,000 salary and $150,000 of vests. The vests add roughly $49,000 of federal income tax, a real rate near 33%. Withholding takes out $33,000. That leaves about $16,000 nobody collects during the year. Bigger vests or a working spouse widen it further.

The IRS does not wait until April. Tax is due as income arrives, and a shortfall accrues an underpayment penalty that works like interest, quarter by quarter. You can see your own gap in the RSU tax calculator.

Two ways to close it

• Extra withholding. File a new W-4 and add a flat extra amount per paycheck (line 4c). Withholding is treated as paid evenly through the year no matter when it comes out, so raising it in the fall can retroactively cover earlier quarters.
• Quarterly estimated payments. Send the IRS the gap yourself in four installments. This works best when vests are large relative to salary and covering the tax through paycheck withholding would shrink your take-home pay too far.

Either way, the safe harbor rule sets the target. Reach 110% of last year's total tax through withholding and payments and no penalty can apply, however large this year's vests turn out. In a big vest year that is usually far less than the full gap, and you settle the rest in April penalty-free.

Sources: IRS Publication 15 · IRS Publication 505