It was supposed to be a celebration. Marcus, a software engineer at a hot startup, watched his company's stock price double over six months. His RSUs had vested throughout the year, and on paper, he'd made an extra $80,000. But when April came around, Marcus got a shock that wiped the smile off his face: he owed $28,000 in taxes.
"I never sold any shares," Marcus told us during our first meeting. "How can I owe taxes on money I never actually received?"
Marcus had fallen into one of the most common—and expensive—equity compensation tax traps. His story isn't unique. Every year, we see smart, successful professionals get blindsided by the tax implications of their equity compensation. The complexity isn't their fault, but the consequences are definitely theirs to bear.
If you're receiving RSUs, stock options, or participating in an ESPP, understanding these tax traps could save you thousands of dollars and countless headaches. Let's dive into the most common mistakes we see—and more importantly, how to avoid them.
Tax Trap #1: The "RSUs are taxed when I sell them" myth
This is the big one—the misconception that costs people the most money and causes the most stress.
The myth: RSUs are taxed when you sell them, like regular stock investments.
The reality: RSUs are taxed as ordinary income when they vest, regardless of whether you sell them or not.
Here's what actually happens when your RSUs vest:
- Taxable event occurs: The moment shares vest, the full fair market value becomes taxable income
- Withholding happens: Your company typically withholds shares to cover taxes (usually 22% federal, plus state taxes)
- You owe the difference: If your actual tax rate is higher than the withholding rate, you'll owe more at tax time
Marcus's situation breakdown:
- $80,000 worth of RSUs vested throughout the year
- Company withheld 22% federal + 6% state = $22,400
- Marcus's actual tax rate: 35% (24% federal + 9.3% California + payroll taxes)
- Actual tax owed: $28,000
- Shortfall: $5,600 he had to pay out of pocket
The trap deepens when people hold onto all their vested shares. They're paying taxes on gains they can't access unless they sell, creating a cash flow crunch at tax time.
The smart approach: Plan to sell enough shares at vesting to cover the full tax liability, not just the amount withheld.
Tax Trap #2: The "sell everything immediately" overcorrection
Once people learn about Tax Trap #1, they often swing too far in the opposite direction.
The myth: Since RSUs are taxed at vesting, I should sell everything immediately to avoid further tax complications.
The problem: Selling large amounts of stock all at once can push you into higher tax brackets and miss out on potential long-term capital gains treatment.
Consider Sarah's situation:
- $120,000 in RSUs vested in December
- Sold everything immediately upon vesting
- Combined with her $180,000 salary, her taxable income jumped to $300,000
- This pushed her from the 24% to 32% federal tax bracket on the last $80,000
A better approach might have been to spread the sales across multiple tax years or coordinate with other tax planning strategies.
The smart approach: Develop a systematic selling strategy that considers your overall tax situation, not just the equity compensation in isolation.
Tax Trap #3: The Alternative Minimum Tax (AMT) surprise with ISOs
Incentive Stock Options (ISOs) create one of the most complex and expensive tax traps in equity compensation.
How ISOs work:
- You can exercise them without paying regular income tax immediately
- The "spread" (difference between exercise price and fair market value) becomes an AMT preference item
- AMT is a parallel tax calculation that can result in much higher taxes
Real-world example: David exercised $200,000 worth of ISOs with a $150,000 spread. He thought he was being smart by not triggering regular income tax. Instead:
- Regular tax on exercise: $0
- AMT calculation: $150,000 spread triggered $35,000 in AMT
- Result: David owed $35,000 in taxes on shares he couldn't sell (pre-IPO company)
The smart approach: Model AMT implications before exercising ISOs. Sometimes it's better to exercise smaller amounts over multiple years to stay below AMT thresholds.
Tax Trap #4: The wash sale rule violation
This trap catches people trying to be smart about tax-loss harvesting with their company stock.
The setup: You own company shares that have declined in value and want to harvest the loss for tax purposes.
The trap: You sell the shares at a loss, then buy them back within 30 days (or buy "substantially identical" securities).
The consequence: The IRS disallows your loss deduction under the wash sale rule.
Common scenarios where this happens:
- Selling company stock at a loss, then receiving new RSU vests within 30 days
- Participating in ESPP purchases while trying to harvest losses on existing shares
- Selling individual company shares while holding company stock in a 401(k)
Real example: Jennifer sold $50,000 worth of company stock at a $10,000 loss in November. Two weeks later, her quarterly RSUs vested, giving her new shares of the same stock. Result: Her $10,000 loss deduction was disallowed, costing her about $2,400 in additional taxes.
The smart approach: Coordinate all equity transactions and be aware of upcoming vesting schedules before harvesting losses.
Tax Trap #5: The state tax surprise
Many people focus on federal taxes and forget about state tax implications, which can be substantial.
The complexity: Different states tax equity compensation differently, and the rules can be especially complex if you move between states.
California's particularly harsh rules:
- Taxes RSUs based on where you performed the work, not where you live when they vest
- Can pursue taxes on stock options even after you've moved to another state
- Complex sourcing rules for multi-state workers
Case study: Alex worked in California when he received ISO grants, then moved to Texas (no state income tax) before exercising them. He assumed he'd avoid California taxes. Wrong. California still claimed taxes on the portion of the options attributable to his work performed in California.
The smart approach: Understand your state's equity compensation tax rules, especially if you're planning to move. Consider timing moves and exercises strategically.
Tax Trap #6: The ESPP "qualified disposition" miss
Employee Stock Purchase Plans (ESPPs) offer great benefits, but the tax treatment depends on how long you hold the shares.
Qualified vs. disqualified dispositions:
- Qualified: Hold shares for 2+ years from grant and 1+ year from purchase
- Disqualified: Sell before meeting both requirements
The tax difference:
- Qualified dispositions get more favorable capital gains treatment
- Disqualified dispositions are taxed partially as ordinary income
Example: Tom bought $25,000 worth of company stock through his ESPP at a 15% discount. The stock went up 20%, so he sold after 6 months for a nice profit. Problem: Because he didn't meet the holding requirements, $3,750 of his gain was taxed as ordinary income instead of capital gains, costing him an extra $700+ in taxes.
The smart approach: Understand your ESPP's specific terms and plan holding periods to optimize tax treatment.
Tax Trap #7: The concentration risk blindness
This isn't strictly a tax trap, but it's a wealth trap that often stems from tax avoidance.
The setup: You hold onto company stock to avoid triggering taxes, building up a concentrated position.
The risk: Your job and your investment portfolio become correlated, amplifying your risk.
Real consequences: We've seen clients lose hundreds of thousands when their company stock declined while they were trying to avoid paying taxes on gains.
Example: Lisa held $400,000 worth of company stock to avoid capital gains taxes. When the stock dropped 40% during a market correction, she lost $160,000—far more than the $60,000 in capital gains taxes she was trying to avoid.
The smart approach: Diversification is more important than tax optimization. Pay the taxes and reduce your risk.
Strategic solutions: How to navigate equity compensation taxes
Now that we've covered the traps, let's talk about smart strategies:
Develop a systematic selling plan
Instead of making emotional decisions, create a systematic approach:
The "thirds" strategy:
- Sell 1/3 of vested RSUs immediately to cover taxes and reduce concentration
- Hold 1/3 for medium-term potential (1-2 years)
- Hold 1/3 for long-term potential (2+ years)
The percentage strategy:
- Sell enough to cover taxes plus an additional percentage for diversification
- Example: If taxes require selling 35% of vested shares, sell 50-60% total
Time exercises and sales strategically
Coordinate with other income:
- Exercise ISOs in lower-income years
- Time RSU sales around bonuses and other variable income
- Spread large exercises across multiple tax years
Year-end planning:
- Evaluate your tax situation in November/December
- Make strategic moves before year-end
- Consider tax-loss harvesting to offset gains
Use tax-advantaged accounts strategically
Backdoor Roth conversions:
- Use equity gains to fund traditional IRA contributions, then convert to Roth
- Creates tax diversification for retirement
Charitable giving:
- Donate appreciated company shares directly to charity
- Avoid capital gains taxes while supporting causes you care about
Coordinate with professional help
Equity compensation tax planning is complex enough that professional guidance often pays for itself:
Tax professionals: Essential for complex ISO exercises and multi-state issues Financial planners: Help integrate equity strategies with overall financial goals Estate planners: Important for large equity positions and wealth transfer
Advanced strategies for sophisticated situations
For those with substantial equity compensation, consider these advanced approaches:
83(b) elections for restricted stock
If you receive actual restricted stock (not RSUs), an 83(b) election can be valuable:
- Pay taxes on the stock's value when granted (usually low)
- All future appreciation is taxed as capital gains
- Must file within 30 days of grant (no extensions)
Prepaid variable forward contracts
For large concentrated positions:
- Lock in a price floor while maintaining upside potential
- Defer taxes until contract settlement
- Complex strategy requiring sophisticated analysis
Charitable remainder trusts
For very large positions:
- Transfer appreciated stock to trust
- Receive income stream for life
- Avoid immediate capital gains taxes
- Benefit charity while reducing estate taxes
Creating your equity compensation tax plan
Here's a framework for developing your strategy:
Step 1: Understand what you have
- Catalog all equity compensation (RSUs, ISOs, NQSOs, ESPP)
- Know vesting schedules and expiration dates
- Understand your company's specific plan terms
Step 2: Model the tax implications
- Calculate taxes on various exercise/sale scenarios
- Consider AMT implications for ISOs
- Factor in state tax considerations
Step 3: Integrate with overall financial plan
- Coordinate with retirement planning
- Consider concentration risk management
- Plan for major expenses (home purchase, etc.)
Step 4: Implement systematically
- Set up automatic selling arrangements where possible
- Create calendar reminders for key dates
- Monitor and adjust as circumstances change
The behavioral aspect: Managing emotions around equity compensation
Beyond the technical tax considerations, equity compensation creates emotional challenges:
Loss aversion: People hate realizing losses, even when it's tax-smart Overconfidence: Success with company stock can lead to overconcentration Regret minimization: Fear of missing out on gains can prevent smart diversification
Strategies for managing emotions:
- Create rules-based systems that remove emotion from decisions
- Focus on after-tax wealth, not pre-tax gains
- Remember that your job already gives you exposure to company success
Common myths and misconceptions
Let's debunk a few more common beliefs:
Myth: "I should never sell company stock because I believe in the company" Reality: Belief doesn't reduce risk. Diversification is always smart.
Myth: "Tax-loss harvesting isn't worth the complexity" Reality: For large portfolios, it can add 0.5-1%+ annually to after-tax returns.
Myth: "I'll deal with taxes when I exercise/sell" Reality: Advance planning can save significant money and stress.
Myth: "My company's HR/benefits team can advise me on tax strategy" Reality: They can explain plan mechanics but can't provide tax or investment advice.
Technology tools for equity management
Several tools can help manage equity compensation:
Equity compensation platforms: Many companies use specialized platforms that provide tax modeling Portfolio management software: Helps track concentration and plan diversification Tax software: Advanced tax software can model complex equity scenarios Financial planning tools: Comprehensive tools that integrate equity with other financial goals
Looking ahead: Preparing for IPOs and liquidity events
If you're at a pre-IPO company, additional considerations apply:
Pre-IPO planning:
- Exercise ISOs before valuation increases
- Consider early exercise if available
- Plan for lockup periods post-IPO
IPO preparation:
- Develop selling plan for lockup expiration
- Consider tax-loss harvesting in other holdings to offset gains
- Plan for estimated quarterly taxes
The bottom line on equity compensation taxes
Equity compensation can be one of the most powerful wealth-building tools available to high-earning professionals. But the tax complexity is real, and the traps are expensive.
The key principles for success:
Plan ahead: Don't wait until tax time to think about implications Stay systematic: Emotion-driven decisions usually cost money Diversify regularly: Your job already gives you company exposure Get professional help: The complexity justifies expert guidance Focus on after-tax wealth: It's not what you make, it's what you keep
Remember, the goal isn't to avoid all taxes—it's to minimize unnecessary taxes while building wealth efficiently. Sometimes paying taxes today is the smart move to reduce risk and create better long-term outcomes.
Ready to optimize your equity compensation strategy?
At Domain Money, our CFP® professionals specialize in helping tech professionals navigate the complex world of equity compensation. We've seen every trap, know every strategy, and can help you create a plan that maximizes your after-tax wealth while managing risk.
From RSU selling strategies to ISO exercise planning, from AMT optimization to concentration risk management, we'll help you turn your equity compensation into lasting wealth without falling into costly tax traps.
Don't let tax complexity prevent you from making smart decisions with your equity compensation. Schedule a free strategy session today to create a personalized plan that works for your specific situation and goals.
The scenarios described in this article are for illustrative purposes only and do not represent actual client situations. Individual results may vary based on personal circumstances, market conditions, tax laws, and specific equity plan terms. Equity compensation tax planning should be implemented in consultation with qualified tax and financial professionals. Tax laws are subject to change.
