Here’s a tip worth a thousand dollars: if you earned supplemental income in the US, then you may owe (a lot) more taxes on it than you think.

TL;DR: for high earners, especially those with stock grants in a public company, there’s a difference between “taxes withheld” and “taxes owed” on supplemental income, and you’re responsible for paying that difference. This can be as high as an extra 15% in taxes (!), so consider setting funds aside ahead of time.

Note: I’m going to use terms loosely and probably inaccurately. I’m not a CPA. Consult a tax professional and all that for the most accurate assessment of your situation.

Time for a story.

Imagine you’re a tech worker making $165,000/year. This puts you right about at the 32% tax bracket but you don’t think about the details too much; you mainly just get reminded once a month that your rent eats up a lot more of your post-tax paycheck than you expected, but you still get to enjoy a nice omakase sushi meal with friends when you feel like it. You can’t complain too much.

Even better, you’re getting a year-end bonus of $50,000! But alas, the tax man strikes again and you end up with ~$30,000 in hand after taxes. Still, not too shabby. You can get yourself that pair of shoes you’ve been eyeing for several months (but only once they go on sale again, of course), and then invest the rest in a mix of tech stock picks on Robinhood that happen to all be companies your friends also work at, and crypto.

Fast forward to April next year and you’re sitting at a coffee shop, in your new shoes, trying to get your taxes done. You finish filling everything in, and WHAT? TurboTax is saying you owe an additional $5,000 in taxes? That can’t be right, because if it is it’s going to all but deplete your cash savings.

What happened?

Number-crunching

Given your salary of $165,000, that indeed puts you at the 32% tax bracket. Think of this as: any additional income you earn will be taxed at 32% or more for federal income tax.

When you receive your $50,000 bonus, you get $30,000 after withholding. This is where chaos and confusion come into play:

• ~40% of your bonus is withheld immediately to pay taxes (22% federal + 10% state in CA + ~7.5% for Social Security, Medicare, etc.) = $20,000 withheld in total
• But notice that federal withholding is only at 22% = $11,000 withheld
• Meanwhile you’ll be held to 32% in federal income tax on your bonus = $16,000 owed
• So you’ll owe an additional $5,000 in taxes on top of the $11K withheld to meet the $16K

Why are you withheld at 22% when you owe 32%? Who knows, but unfortunately that’s just how it is…

(Note: if your supplemental income exceeds $1M then the amount over $1M is automatically withheld at the maximum 37%, the rate of the highest tax bracket. But any amount under $1M is withheld at 22% only.)

Number-crunching intensifies

This can get especially dangerous around stock grants, especially if you go through an IPO and the stock price goes down afterward.

Let’s say you’ve been at your company for 3 years and they IPO!
Here’s a simplified model, say you have 50,000 vested shares at $10/share = $500,000:

• Let’s assume your tax basis is $500,000 based on the $10 share price
  • Your tax basis is actually determined by the value of the shares at the time they land in your brokerage account (“settle”). This can be months after the actual IPO date so the share price, and therefore your tax basis, could be higher or lower
• Similar to your bonus, your $500,000 is withheld at ~40%, including the same 22% withholding for federal income tax = $200,000 withheld in total
  • With stock grants, your brokerage automatically sells stocks at settlement time to pay the withholding amount (“sell-to-cover”) = 20,000 shares sold at $10/share
• Again, federal withholding is only 22% = $110,000 withheld or 11,000 shares sold
• Meanwhile you’ll be held to ~34.7% in federal income tax on your $500K in stocks = $173,500 owed
  • This is >32% because the $500K sum lands you to an even higher tax bracket
• So you owe an additional $63,000 in taxes on your stocks after you get the 30,000 shares in hand

Now, what happens if you decide to not sell your remaining shares and the share price drops to $5?

• Your tax bill remains unchanged (since it’s based on the original tax basis) = $63,000 additional owed
• You have 30,000 shares in hand, now worth only $150,000
• Meaning you’d need to sell 12,600 of your 30,000 shares at $5/share to cover your tax bill (vs. only 6,300 shares at $10/share)

You’d need to sell a lot more shares to pay taxes in this case. You could even end up “underwater” (owing more than you have) if the stock price dips below $2.10. Scary stuff.

Note: in this example you’ll accumulate capital losses here at -$5/share sold, but a large amount of capital losses may be difficult to make use of in a timely manner.

So keep this in mind for any supplemental income you receive! You could owe thousands of dollars more in taxes on it than you were expecting. What I do: calculate how much extra tax I’ll owe and set aside that amount immediately in a savings account just for tax season.