[GUEST POST] Why Your Compensation Mix Matters For Taxes
This month, I have the pleasure of welcoming John McCarthy of McCarthy Tax Preparation as a guest author! John and his team work with many of my clients on complicated tax preparation and tax projection issues, especially when dealing with equity compensation. I’m excited that he could share his expertise on a topic that hits close to home for the types of families I serve.
-Kelly Klingaman
If you’ve ever found yourself with an unexpected balance due at the April 15th tax deadline, and have equity compensation, this article is for you. Let’s talk about how you can take proactive measures now to be better prepared for the next filing deadline and how stock options and equity compensation impact your withholding.
Income Tax Basics for Employees
Whenever you start a new job, there is a flurry of paperwork to read, sign and return to HR. Among those items is a W-4 “Employee’s Withholding Certificate” that tells your payroll department how to withhold taxes for the IRS. While designed to be a fairly straightforward form, the W-4 has undergone numerous changes over the years. In order to fill it out, you’ll need to know a little bit about how the IRS tax system works.
At a high level, the W-4 asks if you will be filing as single, married filing separately, jointly or as head of household. Each of these statuses have different tax rates at different income levels. The form also asks for the number of dependents (for child tax credit purposes) and if you would like any other adjustments or extra withholdings to apply.
The areas you’ll want to pay special attention to are the filing status and extra withholding lines. If you’re married and both spouses work significant hours, I suggest filling out the W-4 to indicate “Single or Married Filing Separately” status. This applies the tax rates a little more accurately when both spouses are working.
If you receive primarily salary and no other forms of compensation like bonuses, equity compensation, commissions, etc., - then life is pretty easy here! Filled out correctly, the W-4 should get you close to your expected tax liability.
But if you have equity compensation, we have a problem…
What Is the IRS “Supplemental Withholding Rate”?
Let’s say you received a bonus this year, received vested Restricted Stock Units (RSUs), or exercised some Nonqualified Stock Options (NQSOs). Well, it turns out that we throw the W-4 out the door because the IRS has special rules for withholding on these items.
The following types of compensation are subject to special supplemental withholding rates:
● Bonuses
● Commissions
● Accumulation of PTO
● Retroactive pay increases
● Payment of non-deductible moving expenses
● Equity compensation (RSUs, NQSOs, etc.)
The standard rate of withholding for Federal tax purposes is 22% for supplemental compensation received under $1,000,000. (It is 37% for income over $1,000,000.)
This becomes problematic for single taxpayers that earn over $95,000 and married couples that earn over $190,000 for 2023. At this level, tax accrues at 24% and will cause you to be underwithheld at the end of the year.
What Are the IRS Tax Brackets?
The IRS releases inflation adjusted tax brackets each year that determine how much tax you pay on the next dollar of taxable income. Knowing your tax bracket can help you assess if your recent bonus or equity compensation event is going to blow up your tax plan for the year.
Here are the 2023 tax brackets:
An important thing to keep in mind is that even if you have income up to the 32% tax bracket, for example, your income still moves through each of the lower tax brackets. In other words, you don’t lose the benefit of the lower brackets and your average tax bracket will generally be lower than your marginal tax bracket.
Let’s look at some examples.
Example 1
Larry & Pat are both employed and receive the following salary:
Larry - $150,000
Pat - $250,000
After the standard deduction, their taxable income for 2023 is $372,300 and their regular tax liability would be $76,800. While Larry & Pat are in the 32% marginal tax bracket, their average tax rate is only 20.6% ($76,800 / $372,300). If the couple did a good job filling out their W-4, they should be in pretty good shape on April 15th.
But what happens if Pat received a $250,000 vest of RSUs during the year?
Example 2
Now Larry & Pat will receive the following:
Larry - $150,000
Pat - $250,000 + $250,000 RSU = $500,000
After the standard deduction, their taxable income for 2023 is $622,300 and their regular tax liability would be $161,594. Larry & Pat are now in the 35% marginal tax bracket, but their average tax rate is 25.9% ($161,594 / $622,300).
If Pat’s company is withholding at 22% on the RSUs, what would the tax impact look like? Let’s assume that Pat & Larry had a perfect W-4 before the RSUs vested:
Larry & Pat are in for a shock on April 15th when they have a surprise balance due of almost $30,000!
Fixing Under Withholding on Equity Compensation
The good news is that once you are aware of the potential for underwithholding on equity compensation there are ways to keep you on track to eliminate an unpleasant surprise at tax time.
The first step is to check with your payroll department and see if your company allows for an election to increase your withholding rate on supplemental compensation. Some of the larger tech companies like Amazon, AirBnb, Google and Meta are starting to allow employees to elect into the higher rates. For many, this is a once per year election in the fall so pay attention if this comes up as part of your annual benefit renewal process.
If your company doesn’t currently allow for an increased withholding election, you can take one of two approaches to pay the IRS an additional amount throughout the year: adjusting your withholding elections or making estimated tax payments.
If your equity and bonus compensation is fairly steady throughout the year, it can often be easier to update your W-4 and increase your Federal withholding by a set amount per paycheck. This can be done on Step 4(c) on Form W-4.
If, however, your equity and bonus compensation is more random, it might make sense to make estimated tax payments to the IRS. The IRS requires you to pay in the lower of 110% of your prior year tax liability or 90% of your current year liability. But even if you aren’t required to send in an estimated payment, you’ll want to save some of your supplemental compensation for the eventual tax bill. If you have questions on your potential IRS estimated tax payment requirements, be sure to reach out to your tax professional for guidance.
And don’t forget, many of the same thoughts above apply for state taxes as well. You can find your state supplemental tax guidelines here, but be sure to verify your state’s website for any recent updates.
Hopefully we’ve helped to demystify some of the complexity around withholding and equity compensation. I would encourage you to run some numbers this summer to eliminate surprises next April 15th.
-John McCarthy, McCarthy Tax Preparation
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