The RSU Tax Trap: When Should You Sell Your Company Stock, and How Can You Avoid Tax Underpayment?
It has been a rocky year for tech stocks.
Since peaking in January, the tech-heavy Nasdaq is down nearly 5,000 points (about 30%). Many COVID-era tech darlings have suffered even more severe fates, highlighted by Peloton, whose shares peaked at around $162.72 in December 2020 and have since plunged below $8 (at the time of writing) — a 95% loss. There are other stark examples. Take Zoom and Zillow for instance, both companies saw their stock price increase 600% during the first few months of the pandemic. Those gains have since evaporated.
There were a number of non-traditional IPOs these last couple of years. Smaller companies utilized SPACs to bring their stock public. While it may sound like the name of a dog, it actually stands for Special Purpose Acquisition Company. We’ll talk about SPACs in detail another time, but for those of you who love pets, take a look at Barkbox stock. Barkbox makes a great product (I know firsthand) but the stock has fallen 90% from its highs.
Let’s talk about how people with Restricted Stock Units (RSUs) can act proactively to capture the value of their hard work. Previously I wrote in an article distinguishing the tax treatment of RSUs compared to incentive stock options (ISOs).
As long as your company’s shares have value, RSUs always result in some amount of gain taxed at ordinary income rates upon vesting. In general, that’s a good thing (especially for Peloton employees whose RSUs vested in December 2020, and who elected to sell most or all of their shares).
But there’s a potential downside to the RSU model. If your RSUs shares vest when the stock price is high, any subsequent fall in the stock price will not reduce your tax bill. (For the sake of simplification, this article will focus only on federal taxes — we work with clients all over the country, and each state has its own rules on withholding taxes for equity awards.)
When RSUs vest, they trigger a taxable event in which you owe ordinary income taxes on the value as of the date of vesting (the rate depends on your overall income for the year, not just the RSU income).
Will my company withhold enough taxes when my RSUs vest?
Maybe. Most company stock plans automatically sell enough shares to cover a 22% federal tax bill — the problem is, 22% is not usually enough.
The majority of my clients fall into the 32% (or even 37%) tax bracket. Many of them are at risk for underpaying their federal income taxes by 10 to 15 cents on the dollar. This may sound trivial, but it can really hurt if the stock falls between your vesting date and the time your taxes are due.
The top three federal tax brackets subtract 32%, 35%, and 37% of income beyond a certain threshold. (In case you need a refresher, here are all the U.S. federal tax brackets.) Notice: All of those percentages are well over the 22% that most employers automatically withhold when RSUs vest.
Rising Tech Professionals
Many of my clients in their thirties working in tech (often as software engineers) are doing better financially than if they had gone to law or medical school (and without the student loans). It is not uncommon for an experienced tech professional to have several hundred thousand dollars of RSUs vest in a given year. If they aren’t aware of their withholding, their tax bills fall tens of thousands of dollars short. We work with clients to avoid being ambushed by this.
Many software engineers receive enough base salary alone to push them into a relatively high tax bracket. When you add their RSU income, it can easily put them in the 32%, 35%, or 37% bracket.
The difference usually goes unnoticed if the stock price continues to climb, or even if it remains stable. However, if the stock price falls substantially by the time the tax bill comes due, the under-withholding can be impactful, if not painful.
This is exactly what we’re seeing with Peloton, whose shares are worth a fraction of what they once were. Depending on the various employees’ RSU plans, the consequences of an outstanding tax obligation and a low-value equity holding could be disastrous.
Let’s run an example for a Peloton employee:
We’ll call our imaginary rising tech professional Ted Ryder. Ted is single, in his early thirties, and makes a $200,000 cash salary plus a grant of 20,000 RSUs through his company’s equity incentive program. Most often, Restricted Stock Units vest on a four-year schedule — so let’s suppose 5,000 shares vest per year.
Here’s Ted’s rocky road:
Top of the hill: In January 2021, suppose 5,000 of Ted’s RSUs vest near their high at around $160 per share, representing a handsome $800,000.
Keep the taxman happy: Ted’s company most likely sold 1,100 shares to cover an estimated federal tax bill (22% of 5,000 = 1,100 shares). The sale results in proceeds of $176,000 (1,100 shares * $160) and is reflected on his paycheck and W2. Like many professionals who love their company, Ted keeps the remaining 3,900 shares invested— without realizing he still owes a large chunk of taxes.
All downhill from here:
Over the next year or so, Ted watches Peloton’s share price fall from $160 to $25 — an 80% decline.
Ted’s 3,900 shares that used to be worth $624,000 are now worth a mere $97,500 (3,900 * $25).
For the previous year, his salary combined with his vested RSUs put his income right at $1 million! ($200,000 salary + $800,000 of RSUs). This brings Ted into the 37% bracket. He still owes another 15% on the $800,000 he got when the first 5,000 shares vested. That’s $120,000 — literally more than his remaining shares are worth.
Like many Americans, he spent a good bit of money during the pandemic and is low on cash. He was counting on the money from his equity award. The only way to pay the remaining $120,000 tax bill is to sell all of his remaining shares and tap into other savings.
What just happened? Ted fell into the RSU Tax Trap, my term for the unpleasant scenario awaiting anyone who does not withhold enough in taxes when their shares vest. Had he sold just 750 more shares at the original time of vesting, he could have avoided this. Now, Ted retains NO value from the $800,000 peak valuation.
It’s easy to say this all with the benefit of hindsight. I always recommend that clients sell at least enough shares to cover their tax bill. Holding shares indefinitely subjects them to the fate of the share price. When the share price falls, so falls the value of your shares — but the tax obligation you owe on any vested shares stays exactly the same. Thus, you have less liquidity with which to fulfill the obligation. In a sense, it’s sort of like borrowing money from the IRS to buy stock.
How to avoid the RSU Tax Trap
1. Resist the myth of infinite gains. From 2009-2019, the S&P 500 set a new record for the most consecutive months of gains (127). Markets took a hit when COVID-19 first struck, but after that, they went on to set new record highs through 2021. It seemed like, when it came to stocks, you just couldn’t lose.
That kind of environment can make people with equity grants reluctant to sell their shares. Seeing the share price rise after a sale is frustrating, but missing out on some upside is better than falling into the RSU Tax Trap. In some cases, people don’t want to sell after the stock price has fallen. They decide to “wait for the stock to go back up” — this cognitive bias is known as loss aversion. Investors try harder to avoid losses than to realize gains. Thus, they pass up opportunities to sell while the share price is rising, and don’t want to sell when the share price is falling. Both scenarios, they believe, would mean suffering a loss.
All of us want to sell at the stock’s top tick, but selling at the top tick is a myth. If you sell incrementally, you realize continuous value, keep the taxman happy, and insulate yourself.
2. Trees do not grow to the sky — sometimes they fall down altogether.
Consider General Electric. For decades, GE was an integral piece of U.S. commerce, manufacturing nearly every electrical appliance that powered our world. From their 1892 founding until September 2000, their share price did almost nothing but rise.
If you held GE stock, you could be forgiven for thinking the gains would never end. Maybe you were a GE lifer with all your retirement savings invested in the company to which you felt so loyal. And then, from October 2000 to February 2009, you watched the impossible happen: GE’s share price fell from around a high of $475 down to just $75 — an 85% reduction in value. Hypothetically, an employee saw $1 million fall to $150,000.
Some of you may have grown up in the 90s, surely you remember the days of Blockbuster or Kodak. These companies did not adapt to the changing environment and ultimately failed.
3. Generate a selling schedule calibrated to your life goals. We have seen how gains are never infinite. They can last a very, very long time — GE enjoyed more than a century of share price gains — but sooner or later, something will disrupt them. I always remind my clients that no matter how great a company is, nothing is a sure thing. Even Jeff Bezos has acknowledged that one day, Amazon will inevitably fail.
When should you sell? How much should you sell? There are no universal answers to these questions. They depend entirely on your life circumstances — what financial obligations you have, how much your company stock is needed to meet these goals, and over what time horizon. If you’re a 25-year-old with no one to support other than yourself, you’re probably not under much pressure to sell (but that doesn’t mean you should exclusively hold). If you’re a 35-year-old saving up for a home down payment, you’ll probably want to take a more active selling approach.
One of the pleasures of my job is helping people iron out the specifics of these plans: taking universal principles and applying them to specific situations. When I see an equity portfolio slowly transform into things of actual value — that dream home, that early retirement, that peace of mind — it brings me tremendous satisfaction.
The RSU Tax Trap is an easy one to fall into. With the right advice, it can be significantly easier to avoid. Do you have RSU holdings that you want to make the most of? Schedule a free discovery session with Chris today.