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Ryan Halpern, CPA, CFP®, PFS Mar 29, 2022 3:59:11 PM 6 min read

Here’s 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 forms of compensation.

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. And large option exercises often come with large tax surprises if the tax withholding is not enough.

Consider taking these actions to cut this year’s tax bill and prepare for the 2022 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 often find that not enough tax was withheld from these awards. I’ve worked with executives whose employers automatically withheld taxes on equity awards 10% to 15% below the proper amount, causing them to owe thousands more at tax time.

I recently met with an executive receiving more company equity awards as part of her compensation package. While her regular income tax withholding was correct, the default withholding tax rate for vesting stock awards was much too low. Unfortunately, her company didn’t provide an option to adjust the withholding equity awards.

Specifically, 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, and she underpaid by $6,000. To avoid spending the $6,000 before the tax was due in April, she proactively made a $6,000 estimated tax payment directly to the Internal Revenue Service to make up for the shortfall.

Make a Safe Harbor Payment

To avoid penalties for underpayment of taxes, anyone unsure of their tax liability can also 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 income). Even if you don’t know how much your income will be in 2022, at a minimum, make safe harbor payments to avoid an underpayment penalty.

For example, let’s assume your 2021 federal income tax liability was $100,000. In 2022, you expect much higher income but you are unsure how it will impact your total 2022 tax bill.

As long as you have paid a total of $110,000 (110% of 2020 federal tax) via withholding and estimated tax payments during 2022, you will avoid underpayment tax penalties. If it turns out that your 2022 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 Ahead 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. For those who need to make adjustments to their regular withdrawal amount from their paychecks, the Internal Revenue Service has a withholding calculator tool: 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. Most states have a similar form to adjust withholding at the state level. The withholding formula is based on marital status, the 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 2020. 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 moving forward.

As the compensation structure for top talent becomes increasingly complex, it’s essential to plan ahead to avoid any 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.

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Ryan Halpern, CPA, CFP®, PFS

Ryan’s experience with high net worth families in public accounting and in a multi-family office setting allows him to offer clients individualized guidance in navigating the complexities of their financial lives.