When a company wants to reward and retain talented employees by offering them equity compensation, Restricted Stock Units (RSUs) are a common grant of choice. Any form of equity compensation can fill this role, and some companies even offer a choice. But RSUs are appealing for their relatively straightforward life cycle compared with other types of equity compensation.
For example, when stock options vest, they may be worth a fortune … or nothing at all. This can generate a more convoluted series of choices to make, as you consider the various cost, benefit, and tax tradeoffs. When RSUs vest, it’s easy. You take ownership of company stock, and it’s yours to keep or sell. Even if it’s worth less than you were hoping for, and even after you’ve paid the taxes due, it’s still worth something.
Employers and employees alike are often drawn to this relative simplicity. Still, there’s more to know about the RSU life cycle if you’re going to make the most of it. Let’s take a closer look, beginning with a diagram of what to expect if your company offers you restricted stock units:
Step 1: Receiving a Restricted Stock Unit Grant
When you are granted RSUs, it generally starts out as a non-event. As the name suggests, the stock is “restricted,” which means:
- You have no ownership rights.
- You can’t sell it.
- You receive no dividend payments.
- You incur no taxes on it at granting.
- If you leave the company, you’ll usually forfeit unvested units.
You’ll take note of the grant date, i.e., the day your company awards restricted stock units to you, as this is often the start date for your vesting schedule. Other than that, until you reach your vesting date(s), nothing much happens. You can think of your pre-vested RSUs as a pledge from your employer: “As long as you remain with our company, you will earn the right to own Y shares, after X time has passed.”
Step 2 – Part 1: Becoming Vested in Your RSUs
After the specified period of time (the most common vesting metric), your RSUs vest. Once they do, things start to happen.
COMPARISON GUIDE
Not All Stock Offers are the Same! Here's a helpful comparison between two of the most common employee stock options.
About That Vesting …
Your employer usually establishes a “cliff” or “graded” vesting schedule for your RSUs, or a combination of the two.
- Cliff Vesting: 100% of the restricted shares vest after a specified period of time. This time frame can vary, but it’s often three years from the grant date.
- Graded Vesting: A set percentage will vest each year, beginning in and lasting for a set number of years. For example, 6.25% of your shares might vest each quarter for 16 quarters (or 4 years).
It’s worth noting, that you should keep an eye on your vesting schedules, particularly if they are quarterly or monthly. Since most of the required action usually happens at vesting, frequent vesting can become a bit of an ongoing nuisance, but monitoring your RSUs is key to finding success.
Step 2 – Part 2: Paying Taxes on Your Vested RSUs
Vesting and paying taxes on the value of your vested shares usually happen simultaneously, regardless of your vesting schedule. There are several exceptions, including:
- Exception #1 – Double-Trigger Provisions: If you work for a private company, your RSUs may include a double-trigger provision. If they do, you won’t take full control over your vested shares and taxes won’t be incurred until your shares vest, AND the company experiences a liquidity-based event, such as an acquisition or an IPO.
- Exception #2 – Forfeiture Risks: While your vested shares remain subject to substantial risk of forfeiture (for example, if they’re contingent on your meeting particular performance benchmarks), you won’t incur taxes—not until your shares have vested AND the forfeiture risk has lapsed. Both events usually occur at same time, but not always.
- Exception #3 – 83(b) Elections: If you hold restricted stock (versus restricted stock units), your plan may allow you to take an 83(b) election to pre-pay your taxes prior to vesting.
Unless an exception applies to you, you’ll owe taxes on the value of your RSU shares when they vest.
Calculating The Tax Impact of RSUs
When RSU shares vest and are delivered, you should be aware of two tax calculations.
- Taxes You Owe: First, you will be responsible for paying federal, state, local, and payroll income tax on the value of the vested units, so you’ll want to project these amounts. Taxable income generated when RSUs vest is taxed at ordinary income rates, the same as your salary.
- Amount Withheld: A forced tax withholding will occur to cover some (possibly all) of the taxes due at vesting, but you’ll want to determine whether the forced withholding is enough.
Here is an example of how it works:
To calculate the taxable income attributable to your vested RSUs, you multiply the number of vested units by their prevailing market value at vest.
For example: If you have 1,000 restricted stock units that vest at $20 per share, you’ve got 1,000 x $20 = $20,000 of reportable income.
All else being equal, the greater the number of vested units and the higher the company stock price at vesting, the higher your income, and your potential tax liability will be.
“Forced” Tax Withholdings vs. “Timing Optional” Out-of-Pocket Tax Payments
When your RSUs vest, your employer will often withhold a statutory amount of tax to cover the estimated tax payments for you. They’ll typically withhold taxes at a federal rate of 22% for statutory income under $1 million, and 37% for income over $1 million—plus applicable payroll, state, and local taxes. (However, some employers may allow you to withhold more.)
Continuing our earlier example, let’s assume you have $20,000 of taxable income and the following withholding requirements:
- Federal Tax: 22% ($4,400)
- Payroll Tax: 7.65% ($1,530)
- Total Withholding: 29.65% ($5,930)
To cover the total $5,930 withholding, your employer would withhold 297 units at $20/share to cover taxes, and deposit the remaining 703 shares into your account, as yours to keep.
This sort of withholding is generally part of the RSU process, and should cover most of your taxes due. However, it’s important to emphasize:
The statutory amounts your employer withholds may not be enough to cover your total tax bill.
For example, let’s assume your current marginal tax rate is 32%. (The marginal rate is the rate at which your next earned dollar will be taxed.) In this example, the total federal tax due on your $20,000 of vested value is $6,400. However, if only $4,400 was withheld specifically for federal income tax (not including payroll tax), you’ll need to come up with additional “timing optional” cash to cover the federal tax bill, either now or at tax time.
No matter how you pay your taxes, the next step is to decide what to do with the after-tax shares you now own …
Step 3: Deciding Whether to Hold or Sell Your Vested RSU Shares
Once your after-tax shares are deposited into your investment account, you own these shares outright, as if you had purchased them on the open market. You now have two options to consider: You can keep holding them, or you can sell some or all of them on the open market.
Option 1: Holding Shares
If you continue to hold the stock, consider the following:
- Stock ownership rights: You’ll have normal stock ownership rights on shares you hold, such as the right to receive dividends, gift shares to others, transfer them to other accounts, and so on.
- Price Risks and Potential Rewards: Should the stock price increase, so too will the value of the stock you hold. Of course, if the stock price drops instead, so will the value of your asset.
- Concentration Risks: By holding the shares, you subject yourself to the concentration risk that comes with owning a single stock position. Concentration risk is when you have too many eggs in one basket, so your portfolio lacks diversification. How much company stock is too much? One rule of thumb suggests not exceeding 10%–15% of your net worth. A better answer, however, may come from considering your personal risk tolerance and investment goals, and how your single company stock position fits into those.
- Greatest Use: It stands to reason, if you’re holding company shares instead of selling them, the proceeds cannot be used for other purposes. Again, if your personal financial goals would be better served by selling the shares, then selling them may be the way to go.
Option 2: Selling Shares
If you decide to sell some or all of your vested RSU shares, you can sell them immediately upon vesting, in the short-term (within a year of vesting), or in the long-term (after a year).
- Selling Immediately: If you sell immediately upon vesting, there shouldn’t be any additional tax impact. Since the shares won’t had time to increase or decrease in value from the vesting price, they shouldn’t generate a capital gain or loss.
- Selling Short-Term: If you sell shares within a year of the vesting date for higher or lower than the vesting price, the capital gain or capital loss will be subject to short-term capital gains tax treatment.
- Selling Long-Term: If you sell the shares more than one year after the vesting date, any gain will be taxed at likely more favorable long-term capital gain rates.
Tax Rates: Short-term capital gains are taxed at your marginal tax rate (like ordinary income). Long-term capital gain rates may be taxed at 0%, 15%, or 20%, depending on your total taxable income. If you sell at a short-term or long-term loss, you may be able to use some or all of the loss to offset other income in the year of the sale, or carry the loss forward to future years.
Step 4: Deciding What To Do After You Sell RSU Shares
As touched on above, one reason you may decide to sell RSU shares is to best align your assets with your personal financial goals and circumstances. For this, generally accepted financial planning principals often suggest selling your vested RSUs immediately upon vesting. You’re incurring the taxes anyway, so why not make best use of the new income?
No matter how you proceed, it’s always a good idea to develop a plan to guide the way. We’ve found this simple structure serves many families well:
- Step 1: Set aside any money needed to cover any taxes incurred.
- Step 2: Invest an appropriate portion of the after-tax proceeds for future spending in or prior to retirement.
- Step 3: Spend the rest on current wants or needs, such as a new home or a new car (without creating an unsustainable “lifestyle creep” that future income streams might be unable to cover).
The details may vary. But proceeding according to a well-ordered and personalized financial plan should help you maximize an outcome that works best for you, upfront and ongoing.
What Else Is There to Know About Restricted Stock Units?
Ultimately, consider yourself fortunate if your employer is offering RSUs to attract, retain, and reward you as an employee. They can be a fantastic opportunity to participate in your company’s growth, be it modest or amazing.
However, don’t let the allure of future potential wealth blind you to the tax implications that come along with it. At the end of the day, the after-tax value is still a lot like receiving a raise at work. Just as you pay taxes on your salary when you earn it, you will need to be mindful of the taxes due as your RSUs vest.
Your vested RSU shares also warrant careful financial planning, to decide how they fit into your overall investment portfolio. Should you keep holding the concentrated shares? Should you sell them and, if so, how will you use the proceeds? Your ideal answers to these common questions will vary. But a financial professional who has helped others consider the same queries can help you decide what makes the most sense for you. Let us know if we can assist.
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.
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