How to Avoid a Big Fat Tax Surprise

Complex compensation plans go hand in hand with being a corporate executive—including stock options, restricted stock units and other equity-based pay.

But these equity awards can result in a large tax bill, especially for executives who earn enough to be in the top federal tax bracket.

That’s because when an executive exercises a large chunk of company stock options, the taxable income often comes in a single year. As a result, large stock option exercises often come with large tax surprises if the tax withholding is insufficient.

Consider taking these actions to cut this year’s tax bill and prepare for the next tax season:

Understand how equity awards are taxed

Executives who exercise stock options or have vesting restricted stock units (RSUs), performance share units (PSUs) and other equity awards might find that not enough tax was withheld. I’ve worked with executives whose employers automatically withheld taxes on equity awards that were 10-15% below the proper amount, causing them to owe thousands more at tax time.

For example, one executive who received equity awards found that the withholding tax rate on her regular income was correct, but the default withholding tax rate for vesting stock awards was much too low. Her vesting PSU resulted in $40,000 of taxable income. Based on her total projected annual income, she was in the 35% marginal tax bracket. However, only 20% was withheld from the award, which means she underpaid by about $6,000.

To manage this situation, she proactively made a $6,000 estimated tax payment directly to the Internal Revenue Service (IRS). This took any worry off her plate and prevented her from accidentally spending the money before April.

Make a “safe harbor” payment

To avoid penalties for underpayment of taxes, anyone unsure of their tax liability can make a “safe harbor” tax payment. 

Safe harbor means that you can avoid penalties if you have paid at least 90% of your actual current year tax or 110% of prior year taxes (or 100% of prior year taxes, depending on your income).[1] Even if you don’t know how much your income will be in a given tax year, at a minimum, you should consider making safe harbor payments to avoid an underpayment penalty.[2]

For example, let’s assume your 2023 federal income tax liability was $100,000. In 2024, you expect much higher income, but you are unsure how it will impact your total 2024 tax bill.

As long as you pay a total of $110,000 (110% of 2023 federal tax) via withholding and estimated tax payments during 2024, you will avoid underpayment tax penalties. If it turns out that your 2024 tax bill is $150,000, you will still owe the $40,000 shortfall, but the $110,000 safe harbor payment should protect you from any underpayment penalties.

Plan for next year—conduct a “paycheck checkup”

To avoid any problems in future years, ask your accountant to run a mid-year tax projection to ensure the amount of taxes withheld from each paycheck is on track for the year.

You may find that the amount needed to be withheld for taxes should be increased. To get an estimate of the right amount, the IRS has a withholding tax calculator: https://www.irs.gov/individuals/tax-withholding-estimator.

If an adjustment is needed, complete a Form W-4, which lets your employer know how much money they should withhold from your paycheck. Some states have a similar form to adjust withholding at the state level. The withholding formula is based on marital status, number of children, income sources and other variables.

I recently met with a man who was starting his second year in a new job. Last spring, he was surprised to receive a large tax bill, including penalties and interest payments, from his work in the previous year. We reviewed his pay stub and discovered that only 20% of his pay was withheld for federal taxes. It should have been around 30%.

Since he unknowingly withheld less money for taxes in his first year with the new company, he had a false sense of security regarding cash on hand and his capacity to spend. He submitted a new Form W-4 to increase his withholding amount moving forward.

As the compensation structure for top talent becomes increasingly complex and potentially more lucrative, it’s essential to plan to avoid any unwelcome surprises—especially the kind of surprises that can mean owing more to the IRS. Taking a few hours now to protect your hard-earned money could pay off next spring.

¹ https://www.hrblock.com/tax-center/irs/tax-responsibilities/avoiding-underpayment-tax-penalty/#:~:text=Estimated%20tax%20payment%20safe%20harbor%20details&text=The%20IRS%20will%20not%20charge,after%20subtracting%20withholdings%20and%20credits
² https://www.irs.gov/businesses/small-businesses-self-employed/estimated-taxes   

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