Why Are Restricted Stock Units Taxed So High?

Restricted Stock Units (RSUs) are a common form of equity compensation offered by many companies, especially in competitive industries. RSUs represent a promise from an employer to grant an employee company stock once certain conditions, usually continued employment, are met. Many individuals receiving RSUs often perceive them as being “taxed so high,” which can be a source of confusion. This article aims to clarify the complexities surrounding RSU taxation and explain why they can lead to a significant tax obligation.

Taxation at Vesting

The primary taxable event for RSUs occurs when they “vest,” meaning the conditions for receiving the shares have been met and the shares are transferred to the employee. At this point, the fair market value (FMV) of the shares on the vesting date is considered ordinary income. This income is treated similarly to regular wages or a cash bonus, meaning it is subject to federal income tax, state and local income taxes where applicable, and Federal Insurance Contributions Act (FICA) taxes.

FICA taxes include Social Security tax and Medicare tax, with an additional Medicare tax applying to wages exceeding certain thresholds. This entire vested value is added to the employee’s other taxable income for the year, such as salary, and is reported on Form W-2, typically in Box 1 (Wages, Tips, Other Compensation), Box 3 (Social Security wages), and Box 5 (Medicare wages). The inclusion of this value as ordinary income at vesting is a significant factor contributing to the perceived high tax burden.

Tax Withholding Mechanics

When RSUs vest, employers withhold taxes from the vested shares or cash equivalent. This immediate withholding can contribute to the feeling of a large tax deduction. A common method used by employers is “sell-to-cover,” where a portion of the newly vested shares is automatically sold to cover the employee’s tax liabilities, including federal, state, local, and FICA taxes. The remaining shares are then delivered to the employee’s brokerage account.

Alternatively, some employers may allow employees to cover the tax liability with cash from other sources, which permits the employee to retain all vested shares. This can be beneficial if the employee believes the stock price will appreciate significantly. Federal income tax withholding on supplemental wages, such as RSU vesting income, is often applied at a flat rate of 22% for amounts up to $1 million, and 37% for amounts exceeding $1 million. This supplemental withholding rate may not always align with an individual’s actual marginal tax rate, potentially leading to either over-withholding or under-withholding.

Taxation of Vested Shares Upon Sale

Once RSUs have vested and the initial ordinary income tax has been paid, the shares become regular stock held by the employee. If these shares are then held for a period and subsequently sold, a second tax event may occur: capital gains or losses. The “cost basis” for these shares is generally established as the fair market value on the vesting date, which is the amount already taxed as ordinary income. This ensures that the initial value of the shares is not taxed again.

Any difference between the sale price and this cost basis will result in a capital gain or loss. If the shares are sold within one year or less from the vesting date, any profit is considered a short-term capital gain and is taxed at the individual’s ordinary income tax rates. If the shares are held for more than one year after vesting, any profit is classified as a long-term capital gain, which typically benefits from lower tax rates. This transaction is reported on Form 1099-B.

Impact of Progressive Tax Rates

The United States operates under a progressive tax system, meaning that higher income levels are subject to higher marginal tax rates. When RSUs vest, their fair market value is added to an individual’s other income, such as salary and bonuses. This cumulative income determines the taxpayer’s overall taxable income for the year. Because RSU income can be substantial, it can push an individual into a higher marginal tax bracket.

While only the portion of income falling within a higher bracket is taxed at that higher rate, the overall tax liability increases. For example, if an RSU vesting event pushes a taxpayer from the 22% bracket into the 24% or 32% bracket, a larger percentage of their total income is subject to higher taxation. It is important to distinguish between the marginal tax rate, which is the rate applied to the last dollar earned, and the effective tax rate, which represents the average rate paid on all income. The progressive nature of the tax system means that while the RSU income itself is taxed as ordinary income, its addition to total earnings can lead to a higher overall tax bill, contributing to the perception of high taxation.