Why Are Restricted Stock Units (RSUs) Taxed So High?
The tax on vested RSUs is often misunderstood. Learn how this equity compensation is valued and integrated into your overall annual income and tax picture.
Receiving a grant of Restricted Stock Units (RSUs) is a benefit, but the tax impact upon vesting often comes as a surprise. The reduction in take-home shares is not due to a special tax on RSUs, but because this compensation is treated just like other income. Understanding how this income is recognized, how taxes are withheld, and what subsequent tax events can occur is the first step in managing this part of your compensation.
Taxation of RSUs as Ordinary Income
The reason RSU taxation feels high is that the value of your shares at vesting is treated as ordinary wage income, not a capital gain. The Internal Revenue Service (IRS) views the shares you receive as a direct payment for services, similar to a cash bonus. The value of the vested RSUs is added to your other compensation for the year, like your salary, and taxed at your standard marginal income tax rates at the moment of vesting.
The taxable income is the number of shares that vest multiplied by the fair market value (FMV) of the stock on the vesting date. For example, if 100 of your RSUs vest on a day when the company’s stock is trading at $50 per share, you have recognized $5,000 of ordinary income. This $5,000 is then added to your total earnings for the year.
This recognized income will be included in Box 1 of your annual Form W-2, “Wages, tips, other compensation,” alongside your regular salary. The tax is not just on the RSUs in isolation but on your entire, now larger, income pool for the year.
The Mechanics of Tax Withholding
A source of the high tax bill comes from the immediate withholding that occurs when RSUs vest. Your employer is required to remit taxes on this compensation, often by treating it as “supplemental wages.” For federal income tax, employers typically withhold at a flat rate of 22% for supplemental income up to $1 million. The excess is subject to a 37% withholding rate.
The income from your vested RSUs is also subject to payroll taxes under the Federal Insurance Contributions Act (FICA). This includes a 6.2% Social Security tax up to the annual wage base limit and a 1.45% Medicare tax with no wage limit. An additional 0.9% Medicare surtax may also apply to earnings over $200,000 for single filers.
State and local income taxes must also be withheld, with rates varying significantly depending on your location. When combined, the flat 22% federal rate, FICA taxes, and state and local taxes can easily result in a total withholding of 30% to 40% or more of the RSU’s value. This withholding is an estimated prepayment of your taxes. Any difference between the amount withheld and your final tax liability will be reconciled when you file your annual tax return, resulting in either a refund or an additional amount owed.
The Second Tax Event When Selling Shares
After your RSUs have vested and you have paid the initial ordinary income tax, a second potential tax event occurs when you decide to sell the shares. This subsequent transaction is governed by capital gains tax rules, not ordinary income tax. A common misconception is that you are being taxed twice on the same money, but the system is designed to tax only the appreciation in value from the time you took ownership. The key to understanding this is the concept of “cost basis.”
Your cost basis in the shares is the fair market value of the stock on the date they vested. This is the exact amount on which you already paid ordinary income tax. When you later sell the shares, you calculate your capital gain or loss by subtracting this cost basis from the sale price. For instance, if your shares were worth $50 each at vesting and you sell them a year later for $65, your taxable capital gain is only $15 per share.
The tax rate applied to this gain depends on how long you held the shares after they vested. If you sell the shares within one year of the vesting date, any profit is considered a short-term capital gain and is taxed at your ordinary income tax rates. If you hold the shares for more than one year after vesting, the profit qualifies as a long-term capital gain, which is taxed at lower rates—0%, 15%, or 20%, depending on your overall taxable income. Selling immediately upon vesting often results in little to no capital gain.
Factors That Amplify the Tax Bill
Two factors can make the tax bill on your vested RSUs feel larger. The first is stock price appreciation between the grant date and the vesting date. A rising stock price directly increases the amount of ordinary income you must recognize. A grant that seemed modest at a low stock price can turn into a substantial income event if the stock performs well, leading to a large tax obligation at vesting.
The second factor is the way a large RSU vesting can push your total annual income into a higher marginal tax bracket. The U.S. tax system is progressive, meaning higher portions of your income are taxed at higher rates. A vesting can elevate your total income beyond a bracket threshold, causing the RSU income to be taxed at a higher rate than you are accustomed to with just your base salary, which is dictated by your overall income level for that year.