CONGRATS! Your employer offers equity as part of their compensation package. You're getting shares of the company and you don't have to trade your time for dollars, in the traditional sense, that is. Woo hoo, passive income!!! We love it!!! Maybe you're in with a phenomenal company like Google, Amazon, Square, Tesla, HEY NOW!!!! This is a great opportunity for sure!
One of the most popular forms of equity based compensation is Restricted Stock Units (RSU's). These don't have a taxable impact when they're granted/awarded; only when they vest. The fair market value that is vested to you gets treated like compensation for income tax purposes - so it gets added to your W2 and is taxed just like your regular salary. It's not uncommon in my industry to see W2's showing $300K+ of wages, with half of it coming from RSU's. That's just how much equity some of these companies are offering. The problem that I see far too often is that employees don't realize the equity is treated as income and thus taxed. Some employers don't offer any education and don't let their employees know how that works so the employee gets a real shocker come tax time. Some employers offer what's called a "sell to cover (STC)" feature which is where they'll take a portion of the shares vested to you and sell them to cover some of the taxes on the equity that will be considered income. An issue that REALLY pisses me off here is that most employers only withhold at the 22% supplemental income rate. Well what's wrong with that you might ask. Let's go back to our $300K W2 from earlier - a person filing jointly with a spouse is in the 24% bracket and a single person with that income is in the 35% bracket, so 22% DOESN'T CUT IT for these folks. When they file their returns, they may have huge balances due because of this shortfall in withholding that's created. I've seen five figure balances, sometimes closer to six, result from this kind of thing. Most people making less than $100K aren't getting this kind of equity and if they are, it's likely not enough to push them into brackets above 22%. Your average American doesn't have thousands in the bank to pay Uncle Sam come tax time unless they knew it was coming (and if they knew, they likely would've made estimated payments to avoid paying that all at once). Some companies do really well with this where they ask if the employee wants to withhold at their true tax rate (kudos to ya'll, the real MVP's). The other thing to be mindful of is that your STC shares are decreasing your equity balance, so you'll have fewer shares in your investment portfolio once those are sold. And when you use this strategy, the STC shares qualify as a short term gain. Because they're sold within a day or so after the shares have vested, it's usually not a big realized gain (or loss), but whatever it is, it's taxed at the higher rate as opposed to long term gains. I'm not at all opposed to the STC strategy, but these are just things to keep in mind since they may play into your overall investment strategy.
The vesting is only the first time tax implications arise with RSU's, but what happens when you sell? Remember those STC transactions I mentioned earlier? I get clients who often don't realize that the "S" truly does mean they SOLD some of their stock, so that does indeed mean a taxable event has happened. Whether it's sold to immediately contribute toward the tax liability, or years down the road, a sale has occurred and Uncle Sam wants his piece of the pie if you made some money on that sale. This again is where the short term vs long term capital gains rates come into play. Hopefully you've waited at least a year and a day after vesting and that the stock sells for greatly more than what it was worth when it was vested to you. But again, just be mindful that the gain is taxable and since your employer is out of the picture on this transaction, you're 100% on the hook for the taxes for that gain. This can be a crazy WIN - you acquire the stock passively, it grows exponentially or at least a lot, AND you get taxed at long term capital gains rates (15% for most folks). CHA-CHING!!!!
Unfortunately the challenges don't stop there though! I oftentimes get clients who just hand over their broker documents without verifying that what's called the stock basis is reported correctly on those forms. There's about a 50/50 chance that it is, which can definitely be bad news for you. There are special adjustments that may need to be made on the return to get it corrected and are very often missed when novice people prepare the return. I get a lot of tax resolution work every year based off of the letters that new clients reach out about. If you've ever received a letter from the IRS and actually opened it (trust me, you'd be surprised how many people don't), you may have noticed the IRS sometimes struggles with clarity and laymen's terms, but do an excellent job of overwhelming taxpayers with LOTS of paperwork to boot. Fun times………..NOT!!!! Again, RSU's are what I see as the most common form of equity based compensation, but don't get me started on ISO's and the AMT impact they potentially have. That's a whole other nightmare of calculations that sometimes results in unexpected high balances due come tax time.
As in most things there's a silver lining, and here it reigns true - you can avoid all of this with effective tax planning with a professional. I highly recommend it because it could save you significant headaches in the long run. We can certainly help with that at Godiva Financial! Schedule a FREE call here!