Understanding Taxes for Corporate Executives: Income Taxes, Tax Rates and Withholding

Taxes are a major pain point for high-earning corporate executives. Clearly, the combination of high tax rates and high taxable income result in some nasty tax bills for executives during peak earning years. However, in our experience the complexity of the United States tax code leads to taxpayer confusion which amplifies the pain of these large - often surprising - tax bills.

In these three articles, our goal is to explain the tax rules that most impact corporate executives. While the article does not cover specific tax saving strategies for corporate executives - for these strategies you can visit our Tax Section - it will hopefully clear up some of the confusion on how a corporate executive’s tax liability is calculated. In Part 1, we discuss:

1.) Income Taxes

2.) Marginal vs. Effective Tax Rates

3.) Why Executives Often Underwithhold

Income Taxes

By far the most influential component of a corporate executive’s tax liability is the Income Tax. The income tax is a progressive tax that is applied to your W-2 earnings which includes earnings from salary, bonus and equity payouts from Restricted Stock, Performance Shares and Employer Stock Options. The progressive nature of the U.S. income tax code means that as your earned income increases so does your tax rate. We receive a lot of questions about how higher income impacts clients’ tax rates so let’s spend a minute explaining.

Marginal vs. Effective Tax Rates

There are two tax rate calculations that matter: Marginal and Effective. The marginal tax rate is the rate you would hypothetically pay on an incremental dollar of taxable income. The effective tax rate is the average rate you pay on all taxable income. Let’s look at an example. Referring to the tax table below, let’s assume taxable income of $500,000 for a married couple filing jointly.

The marginal tax rate is 35% - meaning that if you earn an additional dollar it will be taxed at 35%. However, the effective tax rate is still around 23% because you are not paying 35% on all taxable income, only the taxable amount above $462,500. Most of the taxable income is taxed at rates lower than 35%. The calculation for effective tax rate is Taxes Owed / Total Taxable Income.

We say it over and over, but the key to tax planning is to reduce taxable income when you are in a high marginal tax bracket (i.e. high earning career years) and increase taxable income once you are in a lower marginal tax bracket (i.e. Retirement).

Source: IRS - 2023 Tax Brackets for a Married Filing Jointly Taxpayer

Corporate Executives Often Do Not Withhold Enough

“Why is my tax liability so high if my employer was withholding taxes?” The answer is that your employer was withholding, but not nearly enough. A significant portion of a corporate executive’s compensation is known as “supplemental income”. Supplemental income is money earned outside of a regular payroll check. For a corporate executive, this means that bonus and equity payouts are classified as supplemental income.

So what? Well, supplemental income is typically withheld at 22% for federal income taxes. Unfortunately (or fortunately depending on how you look at it) corporate executives' income typically places them in a much higher tax bracket than 22%.

If you are in the 35% marginal tax bracket and earn a $150,000 bonus and $250,000 in equity compensation, you are already in the hole $52,000 (13% which is the difference between withholding (22%) and marginal tax rate (35%) X $400,000.) Once you combine any under withholding from salary, capital gains, rental income and dividends/interest, it is easy to see how you could owe $75,000 or more when you file your tax return.

In addition to needing to scramble to find $75,000 to pay your tax liability, you may also be required to pay under withholding penalties to the IRS which can be in the $1,000s. The simplest way to avoid nasty tax surprises and penalties is to pay quarterly payments to the IRS instead of waiting until April of the following year to pay one large sum. Additionally, if you owe a penalty you may be able to allocate a portion of withholding to earlier in the year to reduce the penalty amount.

In Part 2, we will discuss Capital Gains, Dividends and Interest. Then Part 3 will tackle how different types of accounts are taxed.

Mark Chisenhall, CFA is the founder of Taurus Financial Planning, a wealth management firm specializing in helping high-earning corporate executives reduce taxes, optimize investments, and accelerate retirement. Check out other relevant posts that take a deeper dive into understanding tax topics such as income taxes and withholding, tax-advantaged accounts, and managing concentrated company stock positions. If you are interested in learning more about working with Taurus Financial Planning, you can schedule an introductory call here.

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