Your company is going public. Should you withhold 22% or 37%?

If a company you worked for is going public, you might be presented with a choice between withholding 22% and 37% of your vesting shares for federal tax withholding. If you're facing this decision, first of all Congratulations! Read on for more information about making your choice.

How does Withholding work?

To understand how withholding works on RSUs, let's consider an example:

Let's say you're vesting 100 shares of stock at a price of $10 per share. We’ll assume you are in a state with no state tax withholding requirement, have elected a 22% withholding rate, and not met your Social Security and Medicare Tax thresholds yet.

Your earnings(100 x $10)$ 1000Federal Tax Withholding(22% of $1000) $ 220Social Security Tax(6.2% of $1000) $ 62Medicare(1.45% of $1000)$ 14.50Total Withholding$ 296.50

Your company would cover this withholding requirement by "selling" some of your vesting shares. In this case, they would sell 30 shares, generating 30 x $10 = $300 in proceeds.

So you would see 100 - 30 = 70 shares and $300 - 296.50 = $3.50 deposited into your brokerage account.

At the end of the year, your W-2 would show the following (in addition to everything else that would otherwise be on it):

Income$ 1000Federal Taxes Paid$ 220Social Security Taxes Paid$ 62Medicare Taxes Paid$ 14.50

Notes:

• The company doesn’t have to “sell” the withheld shares. They could also pay the withholding out of treasury funds – but that’s of no practical difference to you

• Companies can choose to sell fractional rather than whole shares, which would affect the number vested as well as the residual cash deposited into the brokerage account.

• Notice that you could change the price to, say $100, and still end up with almost exactly the same number of shares withheld (modulo capping out SS, bonus medicare withholding, and hitting different withholding thresholds). The price at vest mostly doesn’t affect how many shares you end up with or what they will eventually be worth. So don't fret too much over whether you got the highest price at vest time.

Tax Consequences

Let's consider the tax consequences of your choice to withhold at 22% or 37%

Any vesting above $1M will automatically be withheld (and taxed) at a 37% rate. So, really, this discussion mostly applies to the first $1M of vesting. If your other income this year already puts you into the 37% tax bracket, choosing the 22% option would mean you would have under-withheld by $150K. On the other extreme, if you had no other income this year, had several deductions, and were “Married Filing Jointly”, the extent of the under-withholding could be as little as $70K. So that’s the amount we’re talking about: somewhere between $70K and $150K depending on your tax situation. The potential  over-withholding, if you choose the 37% option, is also roughly in that range.

What happens if you under-withhold?

You will owe the IRS additional taxes, and a possible penalty for under-withholding, when you file your taxes in Q1 2024. At that point you will have to come up with the difference between your withholding rate and tax rate (somewhere between $70K and $150K as discussed above) to pay them. You could cover this liability by selling some of your vested shares at that point. However, If your shares aren't liquid then, you would have to sell other assets or borrow money to pay that off.
PS: If you owe the IRS money, you will want to delay paying until April 15th to keep that money working for you longer.

You will likely not have to pay a penalty for under-withholding thanks to the IRS’s Safe Harbor rules for estimated tax payments.

As long as you’ve paid 110% of your prior year’s tax liability (100% of your prior years liability if you’re not a high earner), you are not required to make estimated tax payments. Since the liquidity event is likely to result in your income for the year being a lot higher than it was in the previous year, it's likely that even a 22% withholding will cover 110% of your prior years taxes. However, you will need to worry about the under-withholding penalty if your income last year was comparable to your income, including the liquidity event, this year, and will need to make estimated payments to ensure that you're covering at least 90% of your liability for this year.

What happens if you over-withhold?

Your over-withholding is effectively an interest-free loan to the IRS. The extent of your over-withholding will be refunded to you when you file taxes for the year (due April 15th the next year, but you can always file earlier - which you should if the IRS owes you).

Additional Withholding

The choice of 22% or 37% only affects your Federal tax withholding. In addition, your company will also withhold for the following reasons:

• State taxes: This depends on the laws and taxes of the state(s) that have a claim on your vesting. These could put you into an under-withholding, or over-withholding situation. Note that these funds are not commingled with Federal taxes. For example, under-withholding for State taxes and over-withholding for Federal taxes doesn’t mean you’re good. You’ll still need to pay your State taxes and any penalties, while waiting for the IRS to refund your over-withholding.

• Social Security: Your company will withhold 6.2% of your vest up to $160,000 (so up to $9,920) unless the company has already withheld SS taxes from your paycheck that year. Note that this will be in addition to any other SS withholding you might have from other sources of income. Since you’ll only owe a maximum of $9,920 for the year, the excess amount will be refunded to you when you file your tax return.

• Medicare Taxes: 1.45% of all vesting plus an additional 0.9% of all income over $200,000. 

Investment Consequences

As I discussed in my series on Concentration Risk, if your equity represents a significant portion of your net worth, you really want to sell as much of the equity as soon as you can unless you believe the stock to be grossly undervalued compared to the market. Note that this is not about the stock being undervalued – it’s about it being undervalued compared to the market. In other words, if you believe it will grossly outperform the market.

So it’s obvious that you should choose 37% withholding, right? That would mean divesting another 15% of your equity, which is the right thing to do, right?

Not so fast. The problem here is that that 15% is not being invested in the market. It’s being given as an interest-free loan to the IRS, so it won’t appreciate in value. That changes the calculus a bit. So your question really is: Do I expect the company's equity to appreciate or depreciate in value between now and April 15th of the next year, and how much of my net worth am I willing to stake on betting that it appreciates? If you believe that the stock will appreciate, you could choose the 22% withholding option and keep that money working for you. However, you would need to account for two risks:

• That the stock depreciates. Would you be ok with losing some of that money?

• That the stock remains illiquid. You would then have to cover your tax liabilities out of your own pocket.

Questions? Comments? Feel free to reach out to me at suhas@prosperowealth.com if you would like to discuss this, or your personal situation, further.