It’s always a good idea to double check your tax withholdings every year, but it is especially critical for executives who receive alternative forms of compensation such as Restricted Stock Units (RSUs) or Incentive Stock Options (ISOs).
Beyond Basic Withholding for RSUs and ISOs
The basics of withholding are pretty widely understood amongst working Americans. As an employee, your employer withholds income tax from your paycheck and captures this information on your W-2. When too much is withheld throughout the year, an employee will receive a refund. When not enough is withheld, an employee will have additional tax due.
Executive compensation plans complicate things and make proactive tax planning a must.
What to Do with RSUs to Avoid Being Underwithheld
When an executive receives an RSU grant, they don’t actually receive the shares all at once. It’s more of an IOU to receive the stock in the future based on specific vesting dates dictated by the company.
As the RSUs vest, the tax event is triggered and reported as income on the W-2. Of course, the employer withholds funds for future taxes due like they do on all employment income, but there is a caveat. RSUs are treated as supplemental income and taxes are withheld at a lower rate than ordinary income. Most employers tend to withhold taxes on RSU income based on a statutory Federal rate of 22%.
This becomes very problematic for someone in upper tax brackets. Suddenly a high-net worth executive is grossly underwithheld and gets a nasty surprise tax bill the following April to prove it!
Don’t Forget about the Alternative Minimum Tax (AMT) on Exercised ISOs
Something similar happens with Incentive Stock Options (ISOs). Even though there isn’t any income tax due on ISOs when they are exercised and held, the exercise is subject to the alternative minimum tax (or “AMT”) in that same tax year. This tax applies to the “spread” between the strike price and the current market price. So what commonly happens is that an unknowing executive does what he or she thinks they are supposed to do and holds their previously acquired ISO shares for at least one year after the exercise date and at least two years from grant date in order to qualify for a more favorable long-term capital gains tax rate vs. ordinary income tax; however, they fail to account for the AMT that will come due the following year. And because of the 12-month holding period requirement, it’s quite possible that the tax filing deadline will take place BEFORE you have access to the sale proceeds. Strategic cash flow management and planning is key!
“I Love Costly Tax Surprises,” said No Executive Ever
Unfortunately, these are two common mistakes we see executives make before they begin working with us. With a limited understanding of how these incentive compensation plans are taxed and the timing of those related tax obligations, they often end up with a tax surprise. Most tax surprises are never a good thing!
Of course, these two tax planning scenarios only underscore the importance in collaborating with your CPA and trusted financial advisory team who specialize in helping executives understand and maximize their incentive compensation - like the Private Wealth Management Team at Halpern Financial.
To schedule a call with our team of experts, simply fill out our Contact Us form and a member of our team will be in touch soon. We have office locations in Virginia, Maryland, and Florida and proudly serve executives and business leaders in all areas of the US and around the globe.