Tax Withholding (Equity)

What Is Tax Withholding on Equity?

Tax withholding on equity compensation is the automatic deduction of income and payroll taxes by your employer when an equity event creates taxable income. Just as your employer withholds taxes from your regular paycheck, they must withhold taxes when you exercise NSOs, when RSUs vest, or when other equity events generate ordinary income. The withheld amount is remitted to the IRS and your state tax authority on your behalf.

The key distinction is that equity withholding uses the supplemental income tax rate — a flat rate applied to income above your regular salary — rather than the graduated rates applied to your base pay. This flat-rate approach makes withholding simpler but often results in under-withholding for high-income employees.

How Equity Tax Withholding Works

Federal Supplemental Withholding Rates

The IRS requires supplemental wages (including equity compensation income) to be withheld at specific rates:

• 22% on the first $1 million of supplemental wages per year
• 37% on supplemental wages exceeding $1 million per year

These rates apply to the ordinary income portion of the equity event. For NSO exercises, this is the spread (FMV minus exercise price). For RSU vesting, this is the full FMV of the vested shares.

Payroll Taxes

In addition to income tax withholding, equity income is subject to payroll taxes:

• Social Security (OASDI): 6.2% up to the annual wage base ($176,100 in 2025)
• Medicare: 1.45% on all earnings, plus 0.9% Additional Medicare Tax on earnings above $200,000 (single)

If your regular salary already exceeds the Social Security wage base, no additional Social Security tax is withheld on equity income.

State Withholding

State income tax is also withheld at rates determined by your state's supplemental withholding rules. California withholds at 10.23% on supplemental wages, for example. Some states have no income tax and therefore no withholding.

Methods of Withholding

Employers collect the withholding through several methods:

• Sell-to-cover: Employer sells a portion of your shares to cover the tax (most common for RSUs)
• Net share settlement: Employer withholds shares equal to the tax liability (the shares never reach your account)
• Cash from payroll: The tax is deducted from your next paycheck (uncommon for large amounts)
• Check or wire: You pay the tax amount to the company directly (rare)

Practical Implications for Startup Employees

Under-Withholding Is Common

The 22% federal supplemental rate is below the marginal tax rate for many employees with equity compensation. If your total income puts you in the 32%, 35%, or 37% federal bracket, plus 10%+ in state taxes, the flat withholding will not cover your actual tax liability. You will owe the difference at tax filing time, and may need to make estimated tax payments to avoid underpayment penalties.

Example: You exercise 20,000 NSOs with a $40 per share spread = $800,000 in supplemental income. Federal withholding at 22% = $176,000. But if your marginal rate is 35%, your actual federal tax is $280,000. You owe an additional $104,000 at filing.

ISO Exercises: No Withholding

When you exercise ISOs, your employer does not withhold any tax — there is no regular income tax due at exercise. However, the AMT adjustment may create a tax liability that you must pay through estimated tax payments. This surprises many employees who assume the lack of withholding means no tax is due.

RSU Sell-to-Cover Math

When RSUs vest and your employer uses sell-to-cover, they sell enough shares to cover taxes at the supplemental rate. This means you receive fewer shares than the total vested amount. For a $100,000 RSU vest, approximately 35-45% of shares may be sold to cover federal, state, and payroll taxes, leaving you with 55-65% of the original shares.

Checking Your Withholding

Review your pay stub or equity exercise confirmation to verify the withholding amounts. Compare the withheld amount to your estimated actual tax liability (using your marginal rate). If there is a shortfall, consider increasing your W-2 withholding for the remainder of the year or making an estimated tax payment.

How It Relates to Exercising Stock Options

Understanding tax withholding helps you plan the cash flow impact of exercising stock options. For NSO exercises, the withholding is automatic but may be insufficient — plan for the shortfall. For ISO exercises, the absence of withholding means you must self-manage the AMT payment. For sell-to-cover exercises, the number of shares you retain depends on the withholding rate. Factor withholding into your exercise decision: the net value you receive or the net shares you keep depends directly on how taxes are collected at the time of exercise.