Increase Tax Withholding On ESPP Gains

I filed my taxes in the first week of April. I received paper I Bonds on April 29, just in time to have them earn the 1.76% rate in the first six months as opposed to the lower 1.18% rate. That’s good. The bad news is for the first time in 20 years I’m paying a underpayment penalty. Not a large one, $15, but it still irks me.

The IRS rules say you must pay by withholding or estimated tax payments:

  • 90% of your tax liability for the current year; or
  • 100% of your tax liability in the previous year (110% if income is over $150k)

I always do an estimate in October to see if I’m safe. If not I would ask the employer to withhold extra. I did the same last year but I didn’t know the "W-2 total YTD" on my paystub didn’t include income from selling ESPP shares even though the employer already knew the shares were sold by then. By the time the employer issued the W-2, the actual number was higher than I projected.

2012 was a great year for my ESPP. I bought the shares at $25 and sold at $45. Because there was no tax withholding on ESPP sale, and my income projection was off, my tax withholding ended up a little short of the 90% threshold.

This is a note for myself and others who run into the same [lucky] situation. Increase payroll tax withholding or pay estimated tax when you have large gains from ESPP sale.

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Comments

  1. slug | sunkcostsareirrelevant.com says

    First blog article in a while where I really learned something. I’ll keep that in mind if I ever end up in another job with an ESPP.

  2. Matt says

    My employer calculates my gain from the offered price and the market price on the day I acquire and taxes me (standard 25%) on that difference, removing the taxes over the next few paychecks. I figured that was a standard practice, but I’ve only ever had this job with an ESPP option.

  3. Peter says

    Sometime later this year I plan to convert my Traditional IRA to a Roth IRA.

    Should I ask my employer to withhold extra?

  4. Harry says

    slug – Thank you for that compliment.

    Matt – Maybe it has to do with “qualified” vs “non-qualified” ESPP. I found this on Fidelity’s website. It says withholding is not required in a qualified ESPP but it is required in a non-qualified plan. Among other things, qualified means that discount can’t be more than 15% and no one can buy more than $25k worth of stocks.

    Peter – If the conversion will be taxable, sure. It’s better to wait until you are in a low tax bracket before you convert though.

  5. Steve says

    Peter – assuming this conversion is the exception, not the rule, all you have to have withheld is 110% of your 2012 taxes. That’s what I did the year I did a big Roth conversion.

    In fact, that’s what I do every year (except the year after that conversion). It takes the guesswork out.

  6. Harry @ PF Pro says

    Haha I forgot to do this last year too, but luckily I over-estimated in other areas so it worked out ok even though I made a sh%$ ton off my ESPP this year. I’m working on an article right now though about the tax treatment of ESPP since my employer reported the gains as income if i sell under 6 months and so did Fidelity, so I would have paid double tax unless i adjusted the basis with fidelity…

  7. Peter says

    Thanks for the responses, Harry and Steve.

    I am already in a low tax bracket. I will make probably around $20,000 this year (I am still in school).

    Last year I didn’t have any federal income tax obligation (other than payroll taxes).

  8. Leigh says

    Similar to not having enough withheld for ESPP gains, my employer by default only withholds 25% federal income tax on my RSU vests. I figured out that I could actually change that number to 28% to match my federal income tax bracket instead of adjusting my withholdings. That has made things a lot simpler!

    I also keep a spreadsheet of my income throughout the year so that I don’t need to rely on the pay stubs. That’s where I do my calculations on how much income tax I should have paid. I can then adjust the forecasting for various different stock prices and see how that changes the picture.

  9. STEVEN J. FROMM, ATTORNEY, LL.M. (TAXATION) says

    I always recommend to my clients to use prior year tax as a safe harbor. This avoids penalty regardless of what your ultimate liability may be on April 15. It is always a gamble estimating what should be paid in for the current year. Your situation shows how this can happen. And there may be other unforeseen tax events that can derail current year projections. In the most extreme cases if you use prior year taxes and you end up owing hundreds of thousands of dollars come tax time you would pay zero in tax penalties for failure to properly estimate.
    Use the safe harbor of prior year tax and you will never have this problem.

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