NSO Supplemental Withholding: 22% and 37% Under §3402(g)

A senior director at a public software company exercised 18,000 NSOs in July 2025. Strike $14, market price $110. Spread: $1,728,000. His W-2 supplemental withholding on the exercise:

First $1,000,000 of supplemental wages at 22% = $220,000
Remaining $728,000 at 37% = $269,360
Total federal supplemental withheld: $489,360
Plus Medicare 1.45% + 0.9% additional = $40,662
Plus California supplemental 10.23% = $176,775
Total statutory withholding: $706,797

His marginal federal rate was 37% on every dollar above $609,350 of taxable income. On $1,728,000 of NSO spread, the true federal tax owed was approximately $598,000 after accounting for the interaction with other income. The withholding of $489,360 left a federal shortfall of $108,640. He owed that amount with his April 15 filing, plus the state and Medicare portions that were fully withheld.

The supplemental withholding rates under IRC §3402(g) are fixed by statute. Employers must use them. The gap between the statutory rate and an individual employee’s true marginal rate is predictable but not adjustable through the W-4.

The statutory rules

IRC §3402(g) and the supplemental rate

IRC §3402(g) and Treasury Regulation §31.3402(g)-1 govern supplemental wages. Supplemental wages include bonus, commissions, overtime, severance, tips, equity compensation, and similar payments that are in addition to regular wages.

The regulation provides two methods for withholding on supplemental wages:

Flat rate method: 22% for the first $1,000,000 of aggregate supplemental wages in the calendar year. Above $1,000,000, 37%.
Aggregate method: combine the supplemental payment with the employee’s regular wages and compute withholding as if the total were a single payment on the regular schedule.

Most large employers use the flat rate method for equity compensation because it is administratively simpler and produces predictable results.

The $1 million threshold

The $1 million threshold is cumulative across all supplemental payments in the calendar year. An employee who received a $500,000 bonus in January 2025 has only $500,000 of 22%-slab capacity remaining. A subsequent $2 million NSO exercise is taxed:

$500,000 at 22% = $110,000
$1,500,000 at 37% = $555,000

The threshold is tracked by the employer, usually via payroll integration. Employees who change employers mid-year can trigger duplicate 22%-slab applications if both employers withhold 22% on the first $1M of supplemental wages, producing a large overwithholding that is reconciled on the return.

The gap between supplemental and marginal

The first $1 million

An employee with $400,000 of regular W-2 wages is in the 35% bracket federally (2025 brackets). Supplemental withholding at 22% undercuts the marginal rate by 13 percentage points.

An employee with $800,000 of regular wages is in the 37% bracket on marginal dollars. Supplemental at 22% undercuts by 15 percentage points.

Above $1 million

Supplemental at 37% matches the top marginal rate exactly. For an employee already in the 37% bracket, withholding above the $1M threshold is essentially accurate.

For an employee whose marginal rate is 35% (inside the 35% bracket), the 37% rate above $1M overshoots by 2 percentage points. This is usually a welcome overwithholding that reduces the April 15 balance.

State supplemental

California’s 10.23% flat supplemental rate is close to the state marginal rate for senior employees. California’s top bracket is 13.3% for income above $1 million, so the supplemental rate undershoots slightly at the very top.

New York City combined state and local marginal rates for senior employees are around 13.5%. New York’s supplemental rate is 11.7%. The gap is roughly 2 percentage points.

Texas, Florida, Washington, and other no-income-tax states have no state supplemental at all. Employees in these states face only federal under-withholding.

The 37% rule’s edge case

Mandatory 37% above $1M

The 37% rate on supplemental wages above $1 million is mandatory under §3402(g)(5). Employers cannot elect to withhold at a lower rate, even if the employee requests it via a W-4. The rule is there to prevent under-withholding on very large payments.

The timing of the threshold trigger

The $1 million threshold is calculated on a year-to-date basis. An employee who receives $900,000 of supplemental in Q1 and $600,000 in Q4 has:

Q1: $900,000 × 22% = $198,000 withheld (all under the threshold)
Q4: First $100,000 × 22% = $22,000; remaining $500,000 × 37% = $185,000; total $207,000

The Q4 event is mostly at 37% because the year-to-date supplemental crossed the threshold early in Q4.

Solving the under-withholding problem

Estimated tax payments

The most common solution is quarterly estimated tax payments under IRC §6654. The safe harbor requires paying in (through withholding plus estimates) either:

90% of current-year tax, or
110% of prior-year tax (if prior-year AGI exceeded $150,000).

For a senior employee with growing NSO income, the 110%-of-prior-year threshold is usually the lower bar. Paying to that level through W-2 withholding plus Q4 estimates avoids the underpayment penalty.

W-4 additional withholding

Filing a W-4 with “additional withholding” on base salary can close the gap for employees whose base salary is large enough to absorb the additional deduction. A $100,000 expected shortfall spread across 26 pay periods is $3,846 per period. For a $400,000 base salary, that is absorbable. For a $180,000 base salary, it starts to pinch.

Coordinated Q4 estimated payment

Some employees prefer a single Q4 estimated payment rather than per-paycheck W-4 adjustments. The estimated payment is made by January 15 of the following year (the deadline for Q4). It counts as paid in the prior year for safe harbor purposes.

A Q4 estimated payment sized to bring total withholding to the 110%-of-prior-year safe harbor avoids penalties. The employee still owes the balance on April 15, but no underpayment penalty accrues.

The IRS notice 2020-65 and beyond

Current guidance

IRS Notice 2020-65 and subsequent guidance confirm the §3402(g) flat-rate supplemental rules. There has been no change to the 22% / 37% structure despite periodic legislative proposals to raise or adjust the rates.

Possible future changes

Legislative discussions have considered tying supplemental withholding to the employee’s actual marginal rate. This would require employer payroll systems to calculate expected annual income, which is administratively complex. As of early 2026, no such change is enacted.

The aggregate method alternative

Employers can elect the aggregate method instead of the flat rate. Under aggregate, the supplemental payment is added to the regular wage payment for the period, and withholding is computed as if the total were a single regular paycheck.

For large equity events, the aggregate method produces much higher withholding. A $2 million NSO exercise in a biweekly pay period would, under aggregate, produce an extrapolated annual income of roughly $52 million (2 million × 26 biweekly periods), triggering maximum marginal withholding on the entire payment.

Most employers find the aggregate method produces excessive withholding that frustrates employees. Flat rate is the dominant choice.

Elective employee rate

A small number of employers allow employees to elect a higher supplemental rate. The election is typically done via a form filed with payroll. Common elective rates include 32%, 35%, or 37%.

If your employer offers this, electing 37% on supplemental wages above, say, $500,000 ensures no under-withholding gap. Microsoft and Salesforce are among the companies known to offer elective higher rates.

Multi-employer issues

Changing jobs mid-year

An employee who changes employers mid-year may hit the $1M threshold twice. Each employer withholds based on its own year-to-date supplemental wages. The employee’s aggregate supplemental wages across employers may be above $1M, but the old employer’s records do not communicate to the new employer.

The result: duplicate application of the 22% slab, with the employee receiving a credit on the annual return for the excess withholding. No penalty, but a temporary cash flow issue.

Simultaneous employment

Dual employment is rare for NSO situations but does occur. Employees working two jobs have similar threshold duplication issues.

Frequently asked

Can my employer withhold at my actual marginal rate?

Only if the employer offers elective higher supplemental rates. The statutory default is 22% / 37%, and the employer cannot use a lower or higher rate without employee election in most cases.

Why does my paystub show a strange supplemental rate?

Some payroll systems display an effective combined rate that blends federal, state, Medicare, and sometimes Social Security. The displayed rate may not match any single statutory number.

What if I have no other supplemental wages in the year?

The full NSO spread is supplemental wages. The first $1M is at 22%; above is at 37%.

Is the 22% rate indexed for inflation?

No. The 22% rate is fixed by §3402(g). It has changed only via statutory amendment (most recently by the TCJA in 2017). The $1M threshold is also not indexed.

How do I calculate my expected shortfall before an exercise?

Compute your true marginal rate for the year including the NSO spread, multiply by the spread, and subtract the supplemental withholding. The difference is the shortfall.

Before your next NSO exercise, compute the shortfall and plan the Q4 estimated payment using the NSO/ISO comparison calculator.