Do you receive some sort of equity in the form of compensation? Are the rules frustrating, confusing, and overwhelming come tax time?
If you answered yes to either of these questions, you’re in good company.
In this blog post, we'll review tax strategies for tech employees who have some kind of stock options or other non-standard compensation.
Understanding the tax ramifications of different forms of compensation is critical for tech employees. If you don’t keep your various tax requirements in mind when making decisions about your options or other equity compensation, you could get hit with a hefty tax bill.
What Type of Compensation Typically Gets Tech Employees in Hot Water?
A standard paycheck usually won’t get you tangled up in a tax mess. That’s because your employer is required to withhold a portion of your W-2 compensation for taxes, so it’s relatively straightforward.
It’s your non-standard compensation, like RSUs, ESPPS, ISOs, etc., and that’s especially true for tech employees because equity often makes up a pretty significant chunk of your total compensation. But, your compensation in the form of equity doesn’t have to be a tax nightmare.
The key with non-standard compensation is to be proactive—know what you have, what you plan to do with it, and how your choices impact your tax bill. Then, plan accordingly.
How Can Tech Employees Get Proactive with Tax Planning?
First, you need to be aware of the type of equity you have and when it triggers a tax liability. That primary step alerts you to when you will encounter a taxable event.
You also need to know when your company will grant you more stock options, and your employer should have made this clear in your hiring offer. If you don’t remember or can’t find your documents, just ask.
Each type of stock option or equity has a different set of tax rules. Some, like RSUs or RSAs, are taxable when they vest or you meet the restriction requirements, and others, like ISOs, are taxable when you sell the shares.
You need to know your specific situation to have a plan in place ahead of time!
For example, assume your compensation includes RSUs. If you understand your specific grant schedule and know when your stock vests, then you’ll also know when you will have a taxable event coming.
You can then start planning for other financial decisions that can offset the taxes you'll owe ahead of time. These choices might include selling off a portion of your vested shares to cover the tax bill or pursuing other tax-deductible financial moves to reduce it, like making larger than regular charitable donations or retirement plan contributions.
Valuable Tax Tips
There are many ways you can be more tax-efficient with your equity compensation, and some strategies are more complex than others. A few simple ones you can easily use are:
- A beneficial tax strategy to offset equity compensation taxes is donating to charity via a donor-advised fund or DAF. A DAF allows you to take large charitable deductions but control when you give the money to the charity.
- You also need to watch your vesting schedule so you can keep track of your holding period. For most types of equity, you must hold the shares for at least a year once they become yours. You want to make sure you are not subjecting yourself to short-term capital gains taxes by selling at the wrong time.
- Suppose you’re at a startup, defined as a company valued at less than $50 million. In that case, you may also be able to simply avoid paying any taxes at all on up to $10 million in gains if you hold the stock for at least five years (among other criteria). This rule is called a Section 1202 exclusion and can be a huge benefit when applicable.
A Common Tech Tax Scenario
Everybody’s tax picture is different, but many share common themes, especially in the tech world.
A common pain point we solve for our tech clients is a surprise tax bill when they file—not the type of surprise you want to see.
We’ve even had clients tell us, “We always owe a large balance on our tax return, and our CPA isn't giving us any insight on why or what we can do about it."
So what can you do?
The first thing I look at in this situation is their RSU income. Unlike withholdings on a base salary which are calibrated pretty well, RSU's are considered "supplemental wage income," which your employer withholds at a flat 22% federal rate for everyone. (The only exception is when income exceeds $1MM, the withholding rate increases to 37%.)
Needless to say, this standard withholding could be far less than the rate someone actually owes on that income if they are in the 32%, 35%, or 37% brackets. Come tax time, they’re still liable for the difference.
Let’s take a look at an example of how this scene might play out.
Assume you have $200k in RSU income and are otherwise in the 35% marginal bracket. Your employer will withhold the standard 22% for federal income tax, or $44k. However, this income will actually face a 35% rate, and your actual liability is $70k.
That means you will owe the $26k difference at tax time! People want to avoid this situation, and proactive tax planning can help you do so. We help clients plan for this and other types of common issues to avoid surprises. Generally, we can do that by increasing their regular withholdings via their W-4 or setting aside extra cash on each vesting date in a bank account that is dedicated to paying the tax.
Work With An Expert
Compensation in the form of equity is tricky enough to plan for.
Add taxation on top of that, and it can be overwhelming. We specialize in helping clients in these situations and would love to talk to you today.