How RSUs Are Taxed at Vesting

Restricted Stock Units (RSUs) are the simplest form of equity comp from a tax perspective. When shares vest, the fair market value of those shares is treated as ordinary W-2 wage income. If you have 1,000 shares vesting at $200 per share, you have $200,000 of ordinary income that year — exactly as if your employer paid you a $200,000 cash bonus on top of your salary.

This income is subject to all the standard wage taxes: federal income tax at your marginal rate, FICA (6.2% Social Security up to $184,500 in 2026, then 0%; plus 1.45% Medicare on all wages, plus 0.9% additional Medicare over $200,000), and state income tax. Companies are required to withhold federal taxes on RSU income, and most use the IRS-mandated supplemental wage rate of 22% for amounts under $1 million.

The 22% withholding rate creates a problem for high earners. If your total wage income (salary + vesting RSUs) puts you in the 32% or 35% bracket, the company under-withheld by 10-13 percentage points on the RSU portion. On $200,000 of RSU income, that's a $20,000-$26,000 surprise tax bill come April. Many engineers learn this the hard way in their first year of significant vesting.

The fix: increase your W-4 withholding to compensate, make estimated quarterly payments, or set aside the gap proactively. Use the W-4 calculator to dial in extra withholding from your salary that compensates for the under-withheld RSU income. Alternatively, ask payroll if they offer 'flat 35% supplemental' withholding (some companies do).

Sell-to-Cover and the Withholding Gap

Most companies use 'sell-to-cover' for RSU vesting: they automatically sell enough shares to cover the federal tax withholding (22% flat for amounts under $1M) and remit the cash to the IRS. You receive the remaining shares.

Concrete example: 1,000 shares vest at $200 each ($200,000 income). Company sells 220 shares ($44,000 worth) to cover federal withholding. They also withhold for FICA from your regular paycheck or sell additional shares for it. You receive 780 shares.

The catch: 22% withholding is correct only if you're in the 22% federal bracket. For most tech workers receiving meaningful RSU grants, you're in the 32%, 35%, or 37% brackets. The company has under-withheld, but the shares are gone — sold at vest. You can't go back and adjust.

Three strategies to close the gap: (1) Sell additional shares immediately at vest to fund the actual tax liability, calculated as your marginal rate minus 22% times the gross RSU value. (2) Increase your salary W-4 withholding via Step 4(c) extra withholding. (3) Make Q1-Q4 estimated tax payments based on the gap. Most well-paid tech workers choose (1) — sell concentrated stock immediately anyway to diversify risk.

Capital Gains After RSU Vest

Once RSUs vest, they're 'just stock' for tax purposes. Your cost basis is the vest-date fair market value (the same value already taxed as ordinary income). If you sell immediately at vest, your capital gain or loss is approximately zero — you simply realize whatever movement happened between the vest moment and the sale.

If you hold the shares, future appreciation creates capital gains: short-term if held less than one year (taxed as ordinary income), long-term if held more than one year (taxed at 0%, 15%, or 20% depending on income, plus 3.8% NIIT for high earners). For a tech worker in the 35% federal bracket holding for over a year, the LTCG rate is 23.8% — saving 11.2 percentage points vs ordinary income.

But concentration risk matters. If your RSU income is 30%+ of your total compensation, holding all the shares creates massive single-stock exposure to your employer. If the company stumbles, you lose income AND wealth simultaneously. The conventional wisdom — sell at vest and diversify — sacrifices the LTCG savings but eliminates correlated risk.

There is no such thing as 'double taxation' on RSUs. Vesting is taxed as ordinary income (already done). Post-vest appreciation is taxed as capital gains. The two events are separate; you're not paying twice on the same dollars. The misconception arises because both events involve the same shares, but the tax base is different (vest value vs gain over vest value).

ISOs and the AMT Trap

Incentive Stock Options (ISOs) have a unique tax structure designed to encourage long-term holding. At grant: no tax. At exercise (paying the strike price to acquire shares): no regular income tax. At sale: capital gains treatment based on holding period. Sounds great — and it is, if you can navigate the AMT trap.

The bargain element at exercise (current FMV minus strike price) is an Alternative Minimum Tax preference item. So while you owe no regular income tax at exercise, you may owe AMT. For 10,000 ISO shares with a $10 strike and $60 current FMV, the bargain element is $500,000. At AMT rates (26% on the first $239,100 in 2026, 28% above), this could trigger $135,000+ of AMT in the year of exercise.

The classic ISO trap: exercise late in the year, hold for the qualifying disposition (more than 2 years from grant AND more than 1 year from exercise), pay AMT in the exercise year, and then watch the stock crash in January. You owe AMT on phantom income that disappeared. Some tech workers in the 2000-2002 dotcom bust and the 2022 tech selloff lost their entire net worth this way.

The countermove: exercise in small batches that don't trigger AMT (use an AMT calculator to model exposure), exercise early in the year so you have tax-loss harvesting time before April, or do an exercise-and-immediate-sale (disqualifying disposition) which converts the spread to ordinary income and avoids AMT entirely. The latter sacrifices the LTCG benefit but eliminates the AMT timing risk.

Qualifying vs Disqualifying Dispositions

An ISO sale is a 'qualifying disposition' only if you held the shares more than 2 years from grant AND more than 1 year from exercise. Both clocks must run. If either fails, you have a disqualifying disposition and the bargain element converts back to ordinary W-2 income — taxed at your top marginal rate, not LTCG.

The math: assume 1,000 ISOs at $20 strike, exercised when shares trade at $100, sold a year and a day later at $150. If you held the post-exercise 1-year period AND it's been 2+ years from grant, it's a qualifying disposition. You report $130 per share ($150 - $20) of LTCG: $130,000 long-term gain, taxed at 15-23.8% federal.

If you sell within a year of exercise (disqualifying disposition), the IRS treats $80 per share ($100 - $20, the spread at exercise) as ordinary W-2 income, and the remaining $50 per share ($150 - $100, post-exercise appreciation) as a separate short-term or long-term capital gain depending on the holding period. The ordinary income portion is taxed at 32-37% — much worse.

Strategic timing: if you exercised in March 2025 and the stock has appreciated further, holding until April 2026 satisfies the 1-year-from-exercise requirement. Selling in March 2026 would be a disqualifying disposition. Many employees fail to track these dates and accidentally trigger ordinary income treatment by selling a few weeks early. Calendar reminders or a brokerage that tracks ISO holding periods are essential.

NSOs: Ordinary Income at Exercise

Non-Qualified Stock Options (NSOs) are taxed more straightforwardly than ISOs. At grant: no tax. At exercise: the bargain element (FMV - strike) is ordinary W-2 income, taxed at your marginal rate, with FICA withholding. At sale: capital gains on any appreciation since exercise.

Concrete example: 5,000 NSOs at $30 strike, exercised when FMV is $80. The $50 per share spread = $250,000 of ordinary income at exercise. At a 35% marginal federal rate plus 9.3% California, that's $111,000+ of immediate tax — payable in cash, even though you only have illiquid shares.

The cash crunch is real. Companies typically do 'cashless exercise' or 'sell-to-cover' on NSO exercises to fund the tax. Some employees use 'exercise-and-hold' (paying tax with outside cash to keep all shares) hoping for capital appreciation, but this concentrates wealth and creates tax liability without proceeds.

After exercise, the new cost basis is the FMV at exercise ($80 in our example). Subsequent gains are short-term or long-term capital gains. To get LTCG treatment, hold for more than 1 year from exercise. There's no AMT issue and no qualifying disposition rules — much simpler than ISOs.

ESPP: Two Tax Events, Often Misunderstood

Employee Stock Purchase Plans (ESPPs) typically offer a 5-15% discount on company stock, often with a lookback provision (buying at the lower of beginning-of-period or end-of-period price). The tax treatment depends on whether your sale is qualifying or disqualifying.

Qualifying disposition (held more than 2 years from offering date AND more than 1 year from purchase date): the discount portion is ordinary income, the remaining gain is long-term capital gain. The ordinary income amount is the lesser of (a) the actual discount captured at purchase or (b) the gain from offering-date FMV.

Disqualifying disposition (sold within either window): the entire discount becomes ordinary income (whether you have a gain or not), plus any post-purchase appreciation is short-term or long-term capital gain depending on the holding period.

Practical example: ESPP with 15% discount and lookback. Offering price $80, purchase price $100, you bought at $68 (15% off the lower of $80/$100). If you sell immediately at $100, the $32 per share is fully ordinary income (disqualifying). If you hold 18+ months and sell at $130, the ordinary income is $12 per share (15% of offering-date $80) and $50 per share is long-term capital gain — much better tax treatment. Most ESPP participants ignore this and sell immediately, losing significant tax efficiency.

Section 1202 QSBS: The 100% Exclusion

Qualified Small Business Stock (QSBS) under Section 1202 offers one of the largest tax benefits in the code: up to $10 million (or 10x basis, whichever is greater) of capital gains can be excluded from federal tax entirely. For early employees and founders of qualifying C-corp startups, this is potentially a multi-million-dollar tax shield.

Requirements: the company must be a domestic C-corporation, have less than $50 million in gross assets when the stock was issued, be in a qualified trade or business (most tech is fine; some service businesses excluded), and the holder must have acquired the stock at original issuance (not from a secondary buyer). The 5-year holding period must be satisfied to claim the exclusion.

Real example: a founder owns stock issued when the company had $5 million in assets, holds for 5+ years, and sells in an acquisition with a $30 million gain. They can exclude $10 million entirely from federal tax — saving $2 million+ in capital gains tax. Some states (like California) don't conform to QSBS, so state tax may still apply.

Stacking strategy: gifting QSBS to family members (spouse, children, trusts) can multiply the per-person $10M exclusion. This is called 'QSBS stacking' and requires careful estate planning. The IRS scrutinizes these structures, but they're legal and used by sophisticated founders to capture multiple exclusions on the same company sale.