Stock Tax True Up: What It Is and Why It Happens

A stock tax true up is a procedure to reconcile the amount of tax withheld from an employee’s stock-based compensation with the actual tax owed. This process is common for employees who receive compensation in forms like Restricted Stock Units (RSUs), where the initial tax withholding may not align with their final tax liability. The true up ensures that the correct amount of tax is paid on this income by adjusting for any initial shortfall.

The Reason for a Tax Shortfall

A tax true up is necessary because the Internal Revenue Service (IRS) treats stock compensation as supplemental income, distinct from regular salary. When RSUs vest, their value is considered supplemental income. The IRS allows employers to withhold taxes on supplemental wages up to $1 million using a flat rate of 22%, which simplifies the process for irregular payments.

This flat 22% withholding rate often creates a discrepancy when compared to an employee’s marginal income tax rate. The United States employs a progressive tax system, meaning income is taxed at increasing rates in higher brackets. For many employees receiving substantial stock compensation, their marginal tax rate is often higher than 22%, with federal brackets reaching as high as 37%.

This difference between the 22% supplemental withholding and an employee’s higher marginal rate causes a tax withholding shortfall. For example, an employee in the 32% tax bracket will have had only 22% withheld from their vested RSUs. This leaves a 10% gap that must be covered to satisfy their total tax obligation, necessitating a true-up payment.

Calculating the True Up Amount

Calculating the amount owed in a stock tax true up involves determining the difference between the actual tax liability on the stock income and the amount that was initially withheld by the employer. This calculation ensures the employee’s total tax withholding for the year accurately reflects their income.

The first step is to determine the total taxable income generated by the stock event. For RSUs, this is the fair market value of the shares on the date they vest. For instance, if an employee vests 100 RSUs and the company’s stock price is $200 per share on that day, the total taxable income from this event is $20,000.

Next, you calculate the total estimated tax liability on that income using the employee’s marginal tax rate. If the employee is in the 32% federal tax bracket, the total tax owed on the $20,000 of RSU income would be $6,400. This figure represents the actual tax burden associated with the stock compensation.

Following this, identify the amount of tax that was already withheld at the flat 22% supplemental rate. On the $20,000 of vested stock value, the employer would have withheld $4,400. The final step is to subtract the amount withheld from the total tax liability, which in this scenario reveals a true up amount of $2,000 the employee must pay.

Methods for Paying the True Up

Once the true up amount is calculated, companies have established procedures for collecting the payment from the employee. The specific options available can be found within the company’s stock plan administration documents or by consulting with the payroll or human resources department.

One of the most common methods for collecting the payment is through a direct deduction from a subsequent paycheck. The payroll department will add the true up amount to the employee’s regular tax withholdings on an upcoming payday. This approach requires no active steps on their part, though it does result in a temporarily lower net pay.

Alternatively, some companies may require the employee to make a direct payment to the payroll department. This could involve writing a check to the company or arranging an electronic funds transfer. This method requires the employee to take proactive steps to remit the funds by the company’s deadline.

How the True Up Appears on Tax Documents

The entire stock compensation event, including the initial withholding and the subsequent true up, is reported on the employee’s year-end Form W-2. This ensures that the IRS has a complete picture of the employee’s earnings and the taxes paid throughout the year. Proper reporting is important for accurate tax filing.

Specifically, the total value of the vested stock compensation is included in Box 1 of the W-2, “Wages, tips, other compensation.” This amount is added to the employee’s regular salary. Box 2, “Federal income tax withheld,” will reflect the total amount of federal tax paid, which is the sum of the initial 22% supplemental withholding and the later true up payment.

The purpose of this detailed reporting is to help the employee avoid potential underpayment penalties when they file their annual tax return. By reconciling the withholding shortfall during the year, the true up process aligns the amount of tax paid with the employee’s actual liability. This reduces the likelihood of a large tax bill or penalties at tax time.