Those planning to liquidate a significant amount of employer stock this year will want to be aware of a little-discussed side effect of recent Fed rate hikes – steep tax penalties.
Having lived through significant drawdowns in 2022, and received a nice market bounce year to date, many employees are understandably eager to offload some concentrated company stock this year. Those looking to do so will want to work closely with their financial advisor and CPA to avoid a nasty surprise come tax time.
IRS Penalties Pegged to Interest Rates
IRS penalties fluctuate based on current interest rates. The underpayment penalty, specifically, is pegged to the Federal short-term rate plus 3%.
Thanks to ultra-low interest rates over the past decade, IRS underpayment penalties have bounced between 3%-5%. At that rate, investors could make the strategic decision to keep their money invested in the market throughout the year rather than pay taxes at the time of stock sale, picking up a few percentage points more in market returns than the penalty rate, and pocketing the difference.
Following the recent rate hikes, however, those who make the mistake of not paying enough in taxes this year will be hit with a whopping 7% underpayment penalty, an annualized rate that gets compounded daily.
Two Ways to Pay
There are two ways for individuals to pay taxes – tax withholding and estimated tax payments. The majority of taxpayers pay through tax withholding, which simply means that taxes are withheld at the source. Most commonly, taxes are withheld from an employee’s paycheck. Employees who exercise employer stock via Restricted Stock Units (RSUs) or Stock Options typically also have the ability to withhold some tax at the time of exercise, but may not have the option to withhold taxes for capital gains if the stock is held after exercise.
Those who are unable to withhold taxes at the time of stock sale, or who are not able to withhold enough in taxes, must make estimated tax payments. Estimated tax payments are due four times each year – April 15th, June 15th, September 15th, and January 15th.
Importantly, estimated tax payments must be paid in the quarter in which the income is received. That means, for example, that an individual who sells a large amount of stock (assuming they realize gains) in August must make an estimated tax payment by the September 15th estimated tax deadline to avoid being subject to the underpayment penalty.
Steering Clear of the Underpayment Penalty
Underpayment penalties are assessed by the IRS when not enough tax is withheld throughout the year. What is considered “enough” is known as the “safe harbor” amount, either 90% of the final tax bill due, or 100% of the prior year’s tax bill (110% for those with AGI greater than $150,000).
For employees with a steady income, estimating 90% of the final tax due isn’t difficult, and typically isn’t necessary, assuming the employee has completed their W4 appropriately. For tips on completing your W4 accurately, read my prior article here.
Those who sell a large amount of employer stock, however, will have additional taxable income that can make it difficult to hit the 90% safe harbor amount via regular paycheck withholding. These individuals must make additional estimated tax payments to ensure they reach the safe harbor amount.
Sold a block of company stock and missed the estimated tax deadline? Those who inadvertently miss the estimated tax payment deadline may still be able to avoid an underpayment penalty by increasing paycheck withholdings to withhold 100%/110% of the prior year’s tax bill. Taxes withheld via payroll are deemed to have been paid evenly throughout the year. This is true even if paycheck withholdings are dramatically increased or decreased from one paycheck to the next.
Work Closely with an Advisor to Avoid Costly Mistakes
Ultimately, those employees who plan to sell their employer stock this year should work closely with professionals to avoid making a costly tax mistake. By understanding the two ways to pay taxes—tax withholding and estimated tax payments—and the safe harbor requirement, taxpayers can steer clear of the underpayment penalty and ensure a smoother tax time experience.