RSU Tax Treatment: What You Owe When Shares Vest

RSUs vs. stock options: simpler mechanics, less obvious tax bill

Restricted stock units (RSUs) and stock options both deliver equity compensation, but they work differently. Understanding the distinction matters because the tax treatment is completely different.

RSUs are simpler: no cash outlay, no exercise decision. Shares vest and you own them. But that simplicity obscures the tax bill. Because the income happens automatically, many RSU holders discover a large tax liability they weren’t tracking.

Tax at vesting: ordinary income, not capital gain

When RSUs vest, the IRS treats the fair market value (FMV) of the shares on the vesting date as ordinary wage income. This means:

• It’s included in Box 1 of your W-2, taxed at your marginal federal income tax rate
• It’s subject to Social Security and Medicare taxes (FICA)
• It’s subject to California income tax (up to 13.3%) with no preferential treatment
• Your employer is required to withhold, but may not withhold enough

There is no election to defer recognition. There is no “hold it longer and get capital gains treatment” option for the vesting event itself. The ordinary income is recognized the moment the shares vest, regardless of whether you sell them.

Why the 22% supplemental withholding rate creates a shortfall

When employers pay “supplemental wages” (bonuses, RSU vesting proceeds, commissions), the IRS allows a flat withholding rate of 22% on amounts up to $1 million (37% above that). This is administratively simple, but it’s not calibrated to your actual tax rate.

For RSU holders earning above $200,000 total, the 22% rate almost always under-withholds:

• Federal: The 32% bracket starts at $197,300 (single) in 2025. The 35% bracket starts at $250,525. The 37% bracket starts at $626,350. If your vesting income is taxed at 35%, the 22% withheld covers only 63% of your federal liability on that income.
• California: California does not have a flat supplemental withholding rate. Withholding is based on your W-4 elections and prior income, and routinely undershoots. At 13.3% state rate, California alone adds more than 13 cents of liability for every dollar of vesting income.
• FICA: Social Security tax applies up to the wage base ($168,600 in 2024). Medicare applies to all wages, with an additional 0.9% on wages above $200,000 for single filers. These may or may not be reflected in employer withholding calculations.

The shares-sold-to-cover mechanic

Most employers handle RSU withholding through a process called shares-sold-to-cover(also called “net settlement” or “sell-to-cover”). Here’s how it works:

1. 1,000 shares vest
2. Your employer calculates the withholding due (e.g., 22% federal + state estimate)
3. Shares worth that withholding amount are automatically sold on the vesting date
4. The proceeds go directly to the IRS and state tax authority on your behalf
5. You receive the remaining shares in your brokerage account

This sale is reported on a 1099-B. Because your cost basis equals the sale price (both are the same-day FMV), the capital gain or loss is typically zero or minimal. It’s not additional income. It’s just the mechanics of collecting withholding.

What shares-sold-to-cover does notdo: it doesn’t cover your full tax liability. It only covers the mandatory withholding at the supplemental rate. The gap between that rate and your actual rate is still your responsibility.

Holding after vesting: short-term vs. long-term capital gain

Once shares vest and you’ve paid ordinary income tax on the FMV at vesting, the shares have a new cost basis equal to that FMV. From that point forward, any additional appreciation (or loss) is treated as a capital gain or loss, not ordinary income.

• Sold within 12 months of vesting: Short-term capital gain, taxed at ordinary income rates (up to 37% federal)
• Sold more than 12 months after vesting: Long-term capital gain, taxed at preferential rates (0%, 15%, or 20% federal, depending on income)
• California: No preferential long-term capital gains rate. All gains are taxed as ordinary income at rates up to 13.3%.

The holding period starts on the vesting date (day after, technically), not the grant date. If your RSUs were granted in 2021 but vest in 2024, the holding period clock starts at vesting.

Holding vested RSUs for more than 12 months can cut your federal capital gains rate from 37% to 20%. In California there’s no state benefit, but the federal math is significant for large positions.

The Q4 estimated payment most RSU holders need to make

Because employer withholding often covers only 22% of a higher tax liability, many RSU holders need to make a quarterly estimated tax payment, usually by January 15 (for Q4), to avoid the underpayment penalty.

The IRS underpayment penalty applies when you owe more than $1,000 at filing and haven’t paid enough through withholding or estimated payments. The safe harbor rules:

• 100% of last year’s tax: If you pay in at least as much as you owed last year, you’re protected, even if you owe more this year
• 110% rule for high earners: If your prior year AGI exceeded $150,000, you need to pay in 110% of last year’s liability to be protected
• 90% of current year tax: If you’ve paid in 90% of this year’s actual liability, you’re protected regardless of prior year

If you have a large vesting event mid-year, calculate the shortfall and consider making an estimated payment for Q3 (due September 15) or Q4 (due January 15). Use the RSU Tax Impact Calculator to estimate the shortfall, then visit the quarterly estimate planner to determine what to pay and when.

California treatment

California treats RSU income the same as federal: ordinary income at vesting. There is no preferential treatment:

• Ordinary income at vesting: taxed at California rates up to 13.3%
• Post-vesting appreciation: taxed as capital gain, but California has no preferential long-term rate. All capital gains are ordinary income for California purposes.
• California Mental Health Services Tax adds 1% on income above $1 million, bringing the effective top rate to 13.3%

If you worked in California when the RSUs were granted but leave before they vest, California may still assert a right to tax the income. California uses a “grant-to-vest” apportionment: the portion of the vesting income attributable to days worked in California is California source income, even if you’ve moved.

Tax documents: what to look for

RSU income flows through two primary documents:

• Form W-2, Box 1:The FMV of vested RSUs is included here as ordinary wages. It’s already folded into your total W-2 wages and doesn’t appear as a separate line item. If you want to see the RSU component, ask your employer for a supplemental earnings statement or check your equity platform (Fidelity, Schwab, Morgan Stanley, E*TRADE, Carta, etc.).
• Form W-2, Box 12, Code V:This code indicates income from the exercise of non-qualified stock options (NQSOs), not RSUs. RSUs don’t generate a Box 12 Code V entry. If you see it and you only have RSUs, something is wrong.
• Form 1099-B:Issued by your broker when you sell shares. Reports gross proceeds. You’re responsible for supplying your cost basis (FMV at vesting) on Schedule D. If you use shares-sold-to-cover, those sales appear here with a basis equal to the FMV on the sale date, so the capital gain is typically zero.
• Form 3922: This is for Employee Stock Purchase Plans (ESPPs), notRSUs. If you participate in both an ESPP and an RSU plan, you’ll receive a 3922 for the ESPP. RSU income is handled entirely through your W-2 and 1099-B. They’re different programs with different tax treatment. Don’t confuse them.