Equity Compensation Withholding: Why the Amount Withheld May Not Equal Your Tax

A company can withhold exactly what the payroll rules require and an employee can still owe substantial tax.

That is not necessarily a payroll mistake.

It is often a mismatch between:

withholding rules

and

final tax liability

The percentage withheld is not a promise about the employee's final tax rate.

Withholding is a payment mechanism

Federal income-tax withholding is money collected during the year toward the eventual income-tax liability.

It is not the final computation.

Actual liability depends on the full return, including wages, filing status, household income, investments, deductions, credits, capital gains, AMT, NIIT, and other taxes.

Why 22% appears with equity compensation

Certain separately identified supplemental wages can use an optional flat federal income-tax withholding method.

For 2026:

22%

for qualifying supplemental wages within the applicable threshold.

RSU settlement and conventional NSO exercise can enter this system.

An employee in a higher marginal bracket can therefore have too little federal income tax collected even when payroll correctly follows the withholding rules.

What happens above $1 million?

For applicable supplemental wages above the annual $1 million threshold from an employer, 2026 withholding uses a mandatory:

37%

rate on the applicable excess.

These are withholding rates, not final tax rates.

Example

Suppose a $200,000 RSU settlement uses 22% federal withholding.

Withheld:

$44,000

That does not establish that $44,000 is the final federal income tax attributable to the additional income.

The broader return can produce a higher or lower result.

RSUs

RSU compensation generally enters the wage system when the applicable settlement event occurs.

Collection methods can include:

• employer share withholding/net settlement;
• broker sell-to-cover;
• payroll cash withholding;
• employee cash payment.

The collection method does not determine final liability.

NSOs

A conventional employee NSO generally creates compensation at exercise.

The spread can be subject to federal income-tax withholding and applicable employment taxes.

A cashless exercise can use sale proceeds to fund the strike price, withholding, payroll taxes, and transaction costs.

ISOs

A qualifying ISO exercise generally does not create regular federal compensation income at exercise.

But it can create an AMT adjustment.

That means:

no regular exercise withholding

does not mean

no potential federal tax liability

ISO and ESPP disposition compensation

A disqualifying ISO disposition or an ESPP disposition can create ordinary compensation.

But statutory-option rules provide special treatment for federal withholding and employment taxes.

Relevant authority includes:

• IRC §421(b);
• IRC §3121(a)(22);
• IRC §3306(b)(19).

W-2 compensation can therefore appear without the normal federal income-tax withholding pattern.

Social Security and Medicare

For 2026:

Social Security wage base: $184,500

Employee Social Security rate: 6.2%

Medicare rate: 1.45%

Additional Medicare Tax: 0.9% where applicable

Medicare does not use the Social Security wage cap.

Additional Medicare uses two threshold concepts

Employers generally begin withholding the 0.9% Additional Medicare Tax once wages paid by that employer exceed:

$200,000

The taxpayer's final thresholds depend on filing status:

• $250,000 married filing jointly;
• $125,000 married filing separately;
• $200,000 other individual filers.

Employer withholding and final liability can therefore diverge.

NIIT is separate

Wage compensation itself is generally outside net investment income.

Later investment income or capital gain from the stock can enter the Section 1411 analysis depending on the taxpayer's facts.

Do not fold NIIT into wage withholding.

Estimated tax is also separate

Equity Compensation Withholding: Why the Amount Withheld May Not Equal Your Tax owns the equity-specific reason withholding and final liability can diverge.

It does not own the generic estimated-tax safe-harbor rules.

Use Capital Gains & Basis — Estimated Tax and Safe Harbors for that analysis.

Common withholding mistakes

Watch for:

• treating 22% as the final federal tax rate;
• assuming employer withholding is customized to the employee's return;
• ignoring the rule for applicable supplemental wages above $1 million;
• assuming ISO exercise cannot create tax because no wage withholding occurred;
• assuming W-2 income always means federal withholding was collected;
• forgetting the Social Security wage base;
• confusing the employer's $200,000 Additional Medicare trigger with the taxpayer's filing-status threshold;
• assuming sell-to-cover covers the entire eventual tax bill.

Related pages

• RSUs: When They Are Taxed and What Happens When You Sell the Shares — identify the compensation event.
• NSOs/NQSOs: Tax at Exercise and Tax at Sale — understand withholding on conventional option exercise.
• ISO Alternative Minimum Tax: Exercise, AMT Basis, and the Minimum Tax Credit — see why ISO exercise can create tax without wage withholding.
• ESPPs: Purchase Discounts, Qualifying Dispositions, and Disqualifying Dispositions — understand statutory-option disposition income.
• Capital Gains & Basis — Estimated Tax and Safe Harbors — use Capital Gains & Basis for payment safe-harbor doctrine.