Chapter 10: Equity comp: the taxes nobody withholds right
Maya's employer withheld federal tax on every dollar of the $340,000 she earned in 2026: $220,000 of salary and $120,000 of vested RSUs. Payroll followed the rules exactly. She still owes the IRS about $14,000 more in April, because the rule for stock compensation withholds at a flat 22% while her real rate on those dollars runs 32% to 35%. Equity compensation is the corner of the tax code where doing everything right still produces a five-figure surprise. This chapter shows you the bill early, fixes the basis error brokers commit constantly, and walks the perimeter of the one tax that can charge you for money you never received.
RSUs: a paycheck that arrives as shares
Restricted stock units (RSUs) are a promise: stay until the vesting date and the company hands you shares. The tax treatment is simple and blunt. On the day shares vest, their full market value becomes ordinary income, exactly as if the company had paid you that much cash and you had bought the stock yourself. The amount lands on your W-2, rides the bracket staircase from Chapter 1, and is owed whether or not you sell a single share. The grant itself is a tax non-event. Vest day is everything, and an RSU has only two taxable moments in its whole life.
The 22% problem
Employers withhold on RSUs and bonuses using the IRS flat rate for supplemental wages: 22% federal on the first $1,000,000 of such pay in a year, 37% beyond that. Most plans sell a slice of the vesting shares to cover it, a process called sell-to-cover, and the paperwork makes everything look settled. But a 22% rate matches a filer whose taxable income tops out near $105,700, the ceiling of the 22% bracket. Stack a six-figure vest on a six-figure salary and the vest dollars actually stand on the 32% and 35% steps of the staircase.
Maya earns $220,000 in salary, and $120,000 of RSUs vested across 2026. Her salary withholding is roughly right, because the W-4 system can see her salary. It cannot see her vests properly: every vest was withheld at the flat 22%, $26,400 in total, while the vest dollars stacked on top of her salary into the 32% and 35% brackets.
Run the exact arithmetic. Salary alone, minus the $16,100 standard deduction, leaves $203,900 of taxable income and a $41,704 federal tax bill. The vests stack on top and push taxable income to $323,900. The federal tax on just the vest layer:
| Slice of the $120,000 vest layer | Rate | Tax |
|---|---|---|
| $52,325 (taxable income $203,900 to $256,225) | 32% | $16,744 |
| $67,675 (taxable income $256,225 to $323,900) | 35% | $23,686 |
| The whole layer | 33.7% average | $40,430 |
What payroll sent the IRS on Maya's $120,000 of vests.
The real federal tax on the vest layer. The $14,030 difference is April's surprise.
The federal gap is $14,030, and that is before state tax. The Personal Finance Guide's Chapter 18 quoted Maya's gap as "about $15,600": that rounder figure priced the whole layer at a flat 35% and folded in the way state income tax stretches the hole, since most states under-withhold supplemental wages the same way. The bracket-exact federal number is the table above; add a California-sized state layer and the total shortfall passes both figures comfortably.
Drop your own salary, vest total, and filing status into the calculator above. It traces your vest layer through the 2026 brackets and shows the gap between 22% withholding and what April will actually want.
A gap this size can also trigger underpayment penalties, which are interest charges that accrue quarter by quarter. Chapter 11 covers the safe harbors that switch them off, and they protect employees just as well as freelancers. The fix itself is mechanical:
Every vest, estimate the gap that day: vest value times the difference between your marginal rate and 22%. Then close it one of three ways: add flat extra withholding on Form W-4 line 4(c) (Chapter 14 shows how), pay quarterly estimates, or park the cash in savings until April while a safe harbor protects you from penalties. Sell-to-cover is a down payment, not the bill.
Selling the shares: the double-tax error
Because the vest-day value was already taxed as wages, that value becomes your cost basis in the shares. Sell later and only the movement since vest is a capital gain or loss, short-term or long-term from the vest date (Chapter 4 prices it; Chapter 5 handles the losses). Sell within days of vesting and the gain is usually pocket change.
Now the error. Brokers often report RSU sales on Form 1099-B with a basis of zero or a blank, because the reporting rules do not require them to include the W-2 income you already paid tax on. Import that form unchecked and the software taxes the entire sale price as gain. Maya selling $120,000 of vested shares for $128,000 should report an $8,000 gain; with a zero basis she would pay capital-gains tax on $128,000, on top of the $40,430 of wage tax she already paid on the same dollars. The cure is the broker's supplemental statement, which shows the true vest-day basis, and an adjustment on Form 8949. Check it every single year you sell.
ESPP: the discount, and when it gets taxed
An employee stock purchase plan (ESPP) lets you buy company stock through payroll at a discount, commonly 15%, sometimes measured against the lower of two dates. The discount is never tax-free; the only questions are when it is taxed and at what rate, and the answer depends on how long you hold.
| Disqualifying sale (early) | Qualifying sale (2 years from offering and 1 year from purchase) | |
|---|---|---|
| When you sell | Before meeting both holding periods | After meeting both |
| The discount | The purchase-day spread (market price minus what you paid) is ordinary income on your W-2 in the year you sell | Ordinary income equals the lesser of the offering-date discount or your actual profit |
| Everything else | Capital gain or loss measured from the purchase-day price | Long-term capital gain |
| What it buys you | The discount banked with no market risk | A lower rate on more of the profit, in exchange for holding risk |
A disqualifying sale sounds like a penalty and often is the smarter play: selling immediately locks in the discount as a near-riskless return and keeps your employer from doubling as your portfolio (the concentration problem in the Personal Finance Guide, Chapter 18).
Jamie's logistics company added an ESPP with a 15% discount. Jamie put in $4,250 over six months, received $5,000 of stock, and sold the same week. The $750 discount went on the W-2 and cost $165 at Jamie's 22% rate. Net result: $585 of nearly riskless profit, about a 14% return on the payroll deductions, no concentration, no drama.
ISOs and the AMT: the tax on money you never received
Incentive stock options (ISOs) give you the right to buy shares at a fixed strike price. Exercise them and the gap between the market value and what you paid, the bargain element, is invisible to the regular tax that year. It is not invisible to the alternative minimum tax (AMT), a parallel tax system with its own rules and its own exemption. Each year you compute both taxes and pay whichever is higher. Exercise ISOs and hold past December 31, and the bargain element counts as AMT income even though you sold nothing and received nothing.
2026 made this squeeze tighter. The AMT exemption is $90,100 single and $140,200 married filing jointly, but it now starts phasing out at $500,000 and $1,000,000 of AMT income, at 50 cents per dollar. OBBBA cut those thresholds sharply and doubled the phaseout speed, so exercises that once kept the full exemption now burn it: inside the phaseout zone, each extra dollar of bargain element faces the 28% AMT rate plus another 14 cents of vanished exemption, an effective 42%.
Maya is weighing a startup offer that includes 20,000 ISOs at a $2 strike. If she exercised when the appraised value reached $12, the bargain element would be 20,000 times $10: $200,000. Stacked on her $340,000 of pay, her AMT income would be about $540,000, past the $500,000 line, shrinking her exemption from $90,100 to $70,100. Run the remaining $469,900 through the AMT's 26% and 28% rates and the tentative tax lands near $127,000, roughly $44,500 above her regular $82,134 bill. That extra tax would be due in April on paper gains she may be barred from selling. A CPA earns their fee here, ideally before the exercise, not after.
The AMT bill that outlived the stock
In the dot-com peak, thousands of employees exercised ISOs at prices like $80 and held for the long-term rate. The AMT taxed their bargain elements at those peak values. By April the shares traded at $4, and some owed more AMT than their entire holding was worth. The defenses are simple: never exercise more than you can pay the AMT on in cash, and remember that selling in the same calendar year as the exercise (a disqualifying sale) erases the AMT event and converts the gain to ordinary income instead. Exercising in January, not December, gives you eleven months to watch the stock before that escape hatch closes.
One consolation: AMT paid on an ISO exercise is not always gone for good. It generates an AMT credit (claimed on Form 8801) that trickles back in future years when your regular tax exceeds your AMT. Recovery is real but slow, often spread over many years, which is cold comfort in the year the bill arrives.
The 83(b) election, in one card
The 83(b) election
If you receive restricted stock (actual shares that vest over time, common at early startups) or early-exercise options, an 83(b) election lets you pay tax now on today's value instead of at each vest on tomorrow's. When today's value is pennies a share, that can convert a future six-figure wage bill into a tiny one and start the long-term clock immediately. The catch is procedural and merciless: the election must be filed with the IRS within 30 days of the grant or exercise. There are no extensions and no late filings, ever. The risk is real too: leave before vesting or watch the value collapse, and the tax you prepaid is not refunded. RSUs cannot use 83(b); this card is for founders and very early employees.
Where people go wrong
- Trusting sell-to-cover. The 22% default is a floor, not a settlement. Estimate the gap every vest year, or April will estimate it for you, with penalties.
- Accepting the 1099-B basis on RSU or ESPP sales. A zero basis taxes your wages a second time. The supplemental statement has the real number.
- Holding vested RSUs out of loyalty or laziness. A vested RSU is fully taxed cash wearing a ticker symbol. Keeping it is a choice to buy your employer's stock today.
- Exercising ISOs in December without an AMT projection. The same exercise in January keeps the same-year escape hatch open for eleven months.
- Missing the 83(b) window. Day 31 is permanent.
Key takeaways
- RSUs are wages at vest, at full market value, taxed whether or not you sell. Grant day is a non-event.
- Withholding on vests is a flat 22%, but Maya's $120,000 layer is really taxed at 32–35%: $40,430 owed, $26,400 withheld, a $14,030 federal gap before state tax.
- Your basis in vested shares is the vest-day value. Brokers often report zero; fix it on Form 8949 or pay tax twice.
- ESPP discounts are always taxed eventually; an immediate sale banks roughly the discount with no market risk.
- ISO exercises create AMT income with no cash attached, and 2026's lower phaseout thresholds ($500,000/$1,000,000, at 50 cents per dollar) make exercise-and-hold riskier. Never exercise more than you can pay the AMT on.
- 83(b): 30 days, no extensions.
Sources: IRS: Topic 427, Stock Options · IRS: Publication 525, Taxable Income · IRS: 2026 Tax Inflation Adjustments · IRS: About Form W-4 · Finvest Personal Finance Guide