Restricted stock and restricted stock units (RSUs) are both commonly-used tools to attract and retain employees. While similar in feel, restricted stock, and restricted stock units are technically different instruments, the details of which go beyond the scope of this article.
Both restricted stock and RSUs allow employees to potentially benefit financially if they meet the vesting requirements set by the employer. Often, those requirements mean staying with the company for a set period of time.
That’s the employer’s incentive to give you these kinds of benefits — but that’s not necessarily a bad thing for you since restricted stock and restricted stock units (or RSUs) can possibly help you increase your net worth. How much you benefit is subject to the stock price. An appreciating stock price means you could benefit more. A depreciating stock price means you could benefit less. Ultimately (unless the stock becomes worthless), the restricted stock could give you something should you meet the vesting requirement.
Here are three things you should love about restricted stock.
1 – Restricted Stock and RSUs are Easier to Understand Than Other Types of Stock Options
As compared to its stock option cousins, restricted stock is easier to understand. Mainly, it’s easier to calculate the value of restricted stock. And there are fewer decisions to make with restricted stock.
Restricted stock and RSUs can be very simple.
- Day 1 – You are given a set number of shares (or units, if you have RSUs), for which no tax is due.
- Wait – Technically, you do not own the stock yet. Restricted stock is typically subject to a vesting schedule, often a period of time that must elapse before you have the right to the shares.
- “Get” Your Shares – On the day the vesting period is met, the restricted stock “vests” and becomes yours, with full ownership rights. The value of the vested shares (number of shares vested times vested market price) is taxable income in the year the shares vest, subject to ordinary income, social security, and payroll tax.
Stock options, on the other hand, are more complicated because you need to track the value above and below a strike price, decide on the best time to exercise the option and deal with the alternative minimum tax (for incentive stock options).
Restricted stock removes much of this kind of thinking, planning, and complexity potentially associated with stock options. The decisions are seemingly made for you.
2 – Your Value Is Easier to Calculate
When your restricted stock or restricted stock units vest, you become the owner of the shares of stock. The math to calculate the value of your shares is remarkably easy.
Total Value = Number of shares vested * Per Share Price.
That’s it. Very easy to calculate
In addition to easily calculating the value, it’s likely that your restricted stock will have a value. Barring a total catastrophe where the stock price falls to zero and becomes worthless, you’ll receive the number of shares times the share price. That’s the case even if that share price is $1 or less.
Non-qualified and incentive stock options are not as easy to value because you must account for the strike price or the price at which you can buy the stock.
The strike price may lead to terms like “in-the-money” or “underwater.” To be in-the-money (a good thing), the share price needs to be higher than the strike price (the price at which you can buy the stock). Underwater stock options mean the current market price is less than the strike price. Therefore, they are typically not worth exercising.
For example, imagine a hypothetical company stock has a share price of $100 per share, and your current strike price to buy the stock is $150 per share. It would not make sense to buy the share at $150 when you can go somewhere else and buy it for $100.
To further complicate stock option value, stock options may have future value (even currently under-water stock options) based on factors such a time to expiration and expected price volatility.
For example, let’s assume stock options have five years until expiration. During the five years until expiration, it’s possible that the share price goes up from the current $100 per share and eventually exceeds the $150 option price. If it does, the previously under-water stock option will have value.
Because of this possibility, it is fair to say that the stock options, even when they are underwater, may be worth something. This complexity of assigning a fair value to stock options is another reason to love restricted stock. Restricted stock is significantly easier to value.
3 – You Can Elect an 83(b) in Hopes of Paying Less Tax
The option to take an 83(b) election creates one major difference between restricted stock and restricted stock units. This election is only available to those with restricted stock, and it allows you to pay income tax when the restricted stock is granted, instead of when it vests.
Usually, restricted stock is taxed when the shares vest. The taxable amount is equal to the vested shares times the share price. But an 83(b) election can potentially help you pay fewer taxes on the restricted stock.
This election is used as a strategy to hopefully lower the amount of tax you will pay on your restricted stock. But in an attempt to pay less in tax, you take on the risk that you will actually pay more in tax than had you not elected the 83(b).
Using an example to illustrate how you may pay less in tax using an 83(b) election, let’s assume the following:
- Number of shares: 10,000
- Share price at grant: $1
- Share price at vest (and final sale): $15
If we assume no 83(b) election, you will be taxed when the 10,000 shares vest. At $15 per share, the total value subject to ordinary income is $150,000. Assuming a flat 37% tax rate (the highest tax rate in 2018), you’ll owe $55,500.
If you opt for the 83(b) election, you are choosing to pay tax on the value of the shares at grant, not when they vest. You make this choice in hopes that the value at grant is less than the value at exercise.
In our example, you’ll be taxed on 10,000 at $1 per share when the shares are granted. Assuming the same 37% tax bracket on $10,000, you’ll owe $3,700.
When the shares vest, the price appreciation between the amount claimed as ordinary income via the 83(b) election ($10,000), and the vested market price ($150,000) is taxed at long term capital gains rates, if we assume 20% (the highest rate in 2018), the total tax due is $28,000. Adding this to the tax paid upfront, we get a total tax paid of $31,700.
Comparing the two, not taking the 83(b) election leaves you with a $55,500 tax bill. Taking the 83(b) election would reduce what you owe in taxes, leaving you with a bill of $31,700.
This hypothetical example is not a suggestion to choose the 83(b) election. The strategy has its own risk and reward tradeoff, and like anything else, it should be considered in the scope of a larger financial strategy.
One additional point to note is that during the vesting period, even if you file an 83(b), you have no right to the shares of stock. Should you forfeit your right to the shares by leaving the company early, you will have paid tax on something that you never actually received.
What Now with Your Restricted Stock?
I love restricted stock because of the simplicity of the stock and the stock units. They offer employees an opportunity to build wealth via the accumulation and appreciation of company stock.
If you find yourself with restricted stock, it’s important to learn about the basics, so you can consider how this benefit fits (or doesn’t) into your financial plan.
Financial planning should be considered to allocate for the pending tax bill during the years your restricted stock vests (or planning for an 83(b)). Planning should also consider the intention to retain the stock shares post vesting or sell the shares and diversify the proceeds into something else. This conversation centers around investment risk tolerance and goals and objectives analysis.
If you have more questions about restricted stock and your personal needs, you can reach me directly by clicking here.
This material is intended for informational/educational purposes only and should not be construed as investment, tax, or legal advice, a solicitation, or a recommendation to buy or sell any security or investment product. Hypothetical examples contained herein are for illustrative purposes only and do not reflect, nor attempt to predict, actual results of any investment. The information contained herein is taken from sources believed to be reliable, however accuracy or completeness cannot be guaranteed. Please contact your financial, tax, and legal professionals for more information specific to your situation. Investments are subject to risk, including the loss of principal. Because investment return and principal value fluctuate, shares may be worth more or less than their original value. Some investments are not suitable for all investors, and there is no guarantee that any investing goal will be met. Past performance is no guarantee of future results. Talk to your financial advisor before making any investing decisions.