Excited to start your new tech job? Be careful when you start…
It was October, 2019 when I realized that I was going to change jobs (from Facebook to Zillow). I was excited, but it was bittersweet; I was working with a lot of great people, and it was going to be hard to say goodbye. On top of that, I was in the middle of a project, and I am not one to leave without having a strong transition plan. So, I pushed my start date to January 2020 so that I could have the time needed to wrap things up and leave my current teammates in a good spot. While I don’t regret this decision, it had unintended consequences that I only just learned about this week, more than two years later in February, 2022.
Why the heck does this matter in 2022? Well, it has to do with one of the only two constants in life, of course: death and taxes (emphasis mine).
Why would a January, 2020 start date effect 2021 taxes (filed in 2022)? Well, it has to do with the common “one-year cliff.”
…which is? In tech, it is common for employees to be paid not just a salary, but in equity compensation as well¹. This equity compensation either comes in the form of Restricted Stock Units (RSUs) or Options. While there are differences between the two², there is an important tax difference: RSUs pay income tax at time of vest, whereas Options pay income tax at time of exercise. RSUs then pay capital gains on top of income taxes at the time of sale. We’ll go into more details on this important nuance shortly, but for the purposes of this article, I am going to focus on RSUs, as you have no control over their taxation at time of vest.
OK, so you didn’t talk about the one-year cliff. Will you tell me what it is this time? Yes, sorry; there’s a lot of context to set! When joining a tech company that pays equity as part of your Total Compensation (TC), the standard structure is that you get 25% of the equity grant every year for the next four years (25% x 4 = 100%). However, it is common that the first year’s 25% isn’t paid out until after the first year; this is commonly referred to as “the one year cliff.”
And this matters because…? Well, since I started my new job in January 2020, I got my one year cliff vest in early 2021. But then I also got my 2021 RSUs throughout the same year as well — 50% of my initial equity grant in one year, not two. This caused an anomalous spike in EOY reported income on my W-2 (roughly 2x the normal amount of equity), and pushed me into a much higher marginal tax bracket.
Boo hoo — pay your taxes, tech bro! I know, I know, but hear me out — the story isn’t over. There’s a reason I am only running into issues now, 10 years into my career in this industry. And it’s because of this anomalous bump in marginal tax rate that it’s so painful.
Before we continue though, a disclaimer: this is not a political, or even anti-tax, post. This has nothing to do with partisan politics, so please do not try to make it so in the comments!
Zillow stock has been in freefall since February, 2021 — exactly the date of my one year cliff vest (which vested at a value of ~$200/share). And Charles Schwab, the brokerage Zillow uses to manage RSUs, has a “Sell to Cover” option, which is described as:
However, it turns out, this “feature” only sells 22% of your shares³, and there is no way to override this number with another number⁴. Fast-forward to today, and Zillow stock is at ~$55/share, or 27.5% of the value as a year ago.
I have to interrupt with another disclaimer: this is not a complaint about stock decreasing, nor is it a complaint with Zillow; in fact, I am very happy at Zillow! Instead, this is a warning to everyone else about a situation that can happen at any company that pays equity as part of compensation. But even more specifically, it is only likely to significantly matter if you get your one-year cliff vest right at the start of the year.
We will not use my personal numbers, but the highest marginal tax bracket in 2021 was 37%. This means that all RSU vests that fall into this highest marginal tax bracket didn’t have 15% of the vest amount sold to pay taxes. This means, that come tax time, if the RSU value has decreased since it’s vest, you may not have the funds to cover the missing taxes owed. In other words, your tax rate for the year for those RSUs can be 100%+. Not selling your RSUs can be the greatest loss possible, as it can cost you more in cash than they are even worth. Put another way, this popular meme is wrong:
Is your mind blown yet?🤯⁵ I won’t share my exact personal effective tax rate for 2021, but it’s a lot higher than the perceived maximum of 37%⁶. You can use this formula to calculate your tax rate for a specific vest :
Tᵥ ÷ Tₛ × effective tax rate × 100
Where Tᵥ = RSU value at time of vest, and Tₛ = RSU value at time of sale. Effective tax rate is something you have to compute yourself, taking multiple things into account such as any RSUs being automatically sold at time of vest.
While I didn’t see this coming — I didn’t know it was possible to pay more than 37% in federal income tax⁷ — the point of this post is to be vulnerable and share this with others. If but one person is helped by this post, it will have been worth it!
But wait — can’t you write off the RSU losses to write down the income tax owed? Nope; you can only write off $3K of capital losses per year⁸. Remember earlier when I said RSUs pay capital gains (or count as capital losses) at time of sale? This is the impact of that. Most people talking about writing off losses in excess of this amount are talking about offsetting capital gains in the same year, not income.
So are you going to sell your RSUs now to help pay the taxes, even though you can’t use them to write off the taxes? It wouldn’t be an artifact of mine if I didn’t share solutions, but I must kick this off with the yet-another disclaimer: this is not financial advice. With that out of the way, we are in a low interest-rate environment, and thus borrowing money via mechanisms such as a HELOC or a stock portfolio loan is an option to consider to pay off the taxes. As an avid M1 finance fan, they make such equity-based loans very easy via their M1 Borrow⁹ product, but most brokerages offer such a feature.
Why not just sell all RSUs as they vest? Why only sell to cover taxes? Well, Charles Schwab does not offer this option an option automatically, at least for Zillow equity. I do not know why that is, but even if it were automatic, that still has issues. See the screenshot below:
Schwab automatically sold my shares at 6% loss that is beholden to the maximum of $3,000 of capital losses written off come tax time. By the time I could manually take action, the shares were down by ~10% (or $20/share). This leads to a “slippery slope” mental fallacy that I fell prey to — that I should wait for a rebound before I sell more. I know about stop losses, and I know how dangerous this slippery slope mentality can be; despite that, I fell prey to it anyway. By the end of the trading window, the stock had slipped by ~40%, not just 10%.
However, I believed in my work and I believed (and still believe) in Zillow. I was willing to risk the upside loss; what I didn’t realize was the tax liability that I was accruing by not selling. Had I known this, I would have sold the “true” amount to cover taxes as close to the time of vest as I could manually achieve, ignoring the 10% loss.
So what will you be doing next year? Well, I won’t be “doubling up” on RSUs in one year, so this issue won’t resurface to the same extent. However, it is important to manually calculate your tax liability, and not trust the system to correctly do it for you. I will create my own gSheet and manage my RSUs using my own calculations, using the exact vest price Charles Schwab reports to the IRS. I will then sell shares to meet my forecasted effective income tax rate, and keep the money in a liquid, non-risky option such as a High Yield Savings Account (HYSA).
In summary, beware one year cliffs in the first half of a year, or at least plan accordingly. But even more importantly, beware brokerages’ “Sell to Cover” option that may not sell enough to, well, cover your taxes. You could end up like me, creating a legal near-100% income tax scenario (or sadly, even worse).
[1] Yeah yeah, Netflix is a famous exception to this rule and pays all cash. So if your new job is with Netflix, you don’t need to read this post.
[2] For more reading on Options vs RSUs, see this SmartAsset article. But note that Options, if unsold, would have avoided the entire scenario outlined in this post. So, while Options are often considered the “riskier” choice, their downside has a floor of $0, whereas RSUs’ downside is below $0. Keep reading to learn more…
[3] This is down from 25% before the Tax Cuts & Jobs Act went into effect in 2018. Thanks to Deepak Verma for this reference!
[4] Or better yet, compute the amount of taxes owed automatically given Schwab and your employer have the necessary information to do so.
[5] Yes, I did just change the perspective of thought; how clever of you to notice 😁.
[6] I am talking about federal income tax only; states can charge additional income tax, but I live in WA state where there is no state income tax.
[7] Given the possibility for Tₛ = 0, the theoretical maximum tax rate for a vest is ∞ (infinity %), as you can pay income tax on something worth $0. Huge thanks to Zlatko Knezevic for helping to figure out this formula!
has a floor of negative infinity, ie they can lose you money. More specifically, they can lose up to 37% (the maximum marginal income tax at the federal level) of their all-time high (ATH) value if none are sold at vest, they vest at their ATH, and then crash to $0. These losses, in the form of taxes paid on an unrealized asset, can be even higher with state income taxes. Keep reading to learn more about this.
[8] You can rollover additional losses YoY. However, some losses can be so great you need capital gains to offset the losses, or you’ll die before ever writing off all of the losses. For reference, $100K of capital losses would take 34 years to write off in full.
[9] This is not a referral link, and I have no financial incentive for sharing it.
