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Restricted stock units (RSUs) are a popular form of equity compensation for publicly traded companies seeking to attract and retain top talent. And, as with other forms of equity compensation, they can supercharge the accumulation of wealth during your career. In this post, I’ll discuss some of the basic characteristics, tax issues, key considerations, and strategies to consider.
What is an RSU?
RSUs represent a promise by an employer to deliver a specific number of company shares to an employee as long as they meet certain vesting requirements. The most common condition is simply continued employment for a predetermined period, usually spanning several years. This method is generally viewed as a reward for continued employment. So, if you continue to work for the company, you’ll receive the shares and the financial benefit.
Performance stock units (or PSUs) are also popular among employers. With these grants, employers not only want employees to stay with the company, but they want to incentivize them to increase shareholder value. Employers have significant leeway in setting the criteria for performance-based shares. PSUs can be dependent on company-wide goals, metrics for a specific department or division, or based on individual performance. Performance-based vesting incentivizes employees to improve company performance and shareholder value. Unlike time-based RSUs, PSUs don’t typically guarantee compensation, but only provide an economic benefit if performance targets are met.
Once an employee meets the vesting requirements, the restrictions “lapse,” the shares “vest,” and the shares are released to the recipient. At that point, they have full rights of ownership and can keep the shares or sell them.
Why Employees Like RSUs
Guaranteed Value
RSUs give employees a share in the company's success, similar to other stock-based incentives. However, RSUs differ from awards such as stock options in a key way: they offer guaranteed value if vesting requirements are met. Stock options only provide the right to buy shares at a set price (the strike price), but if the stock price drops below this strike price, the options have no intrinsic value, just time value (this means the options are “underwater”). With RSUs, unless the company goes bankrupt, employees are assured compensation at vesting. This removes the risk of the award becoming worthless and provides employees with peace of mind that they will receive a financial benefit from the shares once delivered.
Simplicity
Stock options require exit strategies. After an option vests, you must decide when to exercise and take ownership of the shares. However, RSUs don’t come with the same challenges. Vesting dates and requirements are set by your employer, not you (although, sometimes the details are negotiable). The price of the stock on the day of vesting determines what value you receive, so no guesswork is required on your part. Some might view this as a negative, but when it comes to making investment decisions, there is value in simplicity.
However, RSUs still require planning so don’t be lured into a state of complacency. Once shares vest, decisions must be made whether to keep all shares, sell all shares, or retain a portion of the shares. Additionally, you will need to plan for tax withholding, determine if estimated tax payments are required, and understand how best to deploy the proceeds if some or all of the stock is sold.
Tax Implications
When granted, RSUs hold no immediate tax consequences. A taxable event doesn’t occur until the shares vest. At vesting, the full fair market value of the shares received is treated as ordinary income subject to federal, state, and local taxes, as well as Social Security and Medicare taxes. The compensation income will show up on your Form W-2 and your employer is required to withhold taxes.
To illustrate, you receive 1,000 vested shares valued at $50 each. The $50,000 fair market value would be taxed as ordinary income on your Form W-2 and your employer will withhold applicable taxes.
After vesting, the shares are yours to keep or sell. When the shares are ultimately sold, the sale will result in a short or long-term capital gain or loss and taxed accordingly.
Tax Withholding
Not all companies approach tax withholding in the same way. Before your shares vest, your company might give you one or more of the following options:
Withhold-to-Cover (also called Net Share Settlement): You surrender some vested shares back to the company. The company uses these shares to cover your tax obligation and deposits the payroll taxes on your behalf. This is by far the most common method used for RSUs.
Sell-to-Cover: A portion of your shares are sold to cover the taxes. The broker will automatically do this on your behalf.
Salary Deduction: The tax amount is deducted from your salary, either as a lump sum or spread over multiple pay periods.
Direct Payment: You pay the taxes by check on the vesting date or within a specified timeframe afterward.
Stock Swap: In rare cases, companies allow you to use already-owned company stock to pay the taxes.
RSUs and other forms of equity compensation are considered supplemental income. If your supplemental income is under $1 million, most employers will withhold taxes based on the flat rate for supplemental wages, which is set at 22%. However, some employers will allow you to withhold at a rate based on your W-4 elections, but only if it would result in a tax higher than 22%. If your supplemental income is over $1 million, the withholding rate must be the highest marginal tax rate, currently 37% at the Federal level.
Check with your employer prior to vesting to determine what tax withholding method(s) they use or offer. And, for those who are stuck with a flat withholding rate of 22%, be prepared for owing additional tax as this amount is likely insufficient.
Example
Let’s walk through a complete example from start to finish.
On June 30th you are granted 1000 RSUs that will vest in 1 year if you are still employed by the company. At this point no income has been received and no taxes are due.
On June 30th of the following year the shares vest while the stock is trading at $50 per share. You now have $50,000 (1,000 shares multiplied by $50) of ordinary income that is reported on your Form W-2.
Your combined tax withholding rate is 40% (this is comprised of federal, state, Social Security, and Medicare taxes). Your employer uses the withhold-to-cover method and will withhold 400 shares to cover the taxes.
$50,000 income multiplied by 40% tax withholding equals $20,000 tax due
$20,000 tax divided by $50 share price equals 400 shares
The $20,000 tax withholding will appear on your Form W-2 and you are left with 600 shares that have a cost basis of $30,000 (600 shares multiplied by $50).
A week later you sell the shares when the stock is trading at $55 per share. The sale results in a short-term capital gain of $3,000 ($33,000 sales price minus $30,000 cost basis).
There are two key points to be aware of. 1) Your employer is only required to withhold amounts for shares that vest, not for capital gains. If you have capital gains from selling shares, you will have to account for this tax separately. 2) Employers are not required to ensure the withholding amount for vested shares is accurate given your specific tax situation. Tax projections should be run to determine if appropriate taxes were withheld. If not, consider making estimated payments to avoid underpayment penalties
Key Considerations
RSUs come with different rules and characteristics than other forms of equity compensation. Additionally, employers have leeway when adopting rules for their RSU plan, which may differ from that of another company. For this reason, you should review all plan documents and the grant agreement so you fully understand the details of your awards and can make informed decisions. In addition to the number of shares granted and the corresponding vesting dates, plan documents will answer many of your questions and cover topics such as:
Accelerated Vesting: If your employer’s company is acquired or merges with another company, it is common for award grants to vest on an accelerated basis. Rather than waiting for the full term of the vesting schedule, the vesting process is accelerated and compensation income is recognized when the sale or merger is complete (or some other nearby date). This can potentially create a financial windfall for those holding significant unvested shares.
Dividends: For companies that issue stock dividends, holders of unvested RSUs won’t receive them. However, some employers will pay dividend equivalents on unvested shares. These dividend equivalents will be placed in escrow and provided to you when the vesting requirements are met. Because they are not dividends and are “equivalents,” they are not taxed as dividend income but as ordinary income.
Voting Rights: When you own shares of stock, you are afforded voting rights for each share of stock you own, but unvested RSUs do not provide voting rights.
Vesting Deferral: Although vesting dates are set by your employer, many companies allow employees to defer the distribution of awards and delay taxation. This is a complex topic that requires a deeper discussion, but in simple terms, vesting deferral allows you to defer share delivery to future years when you perceive you will be in a lower tax bracket, and your need for income will be greater. It’s important to note that only income taxes are deferred and not Social Security or Medicare taxes, but making the deferral could create a tax arbitrage benefit.
Strategic Considerations for Maximizing RSU Benefits
Navigating the intricacies of RSUs requires careful strategic planning to optimize their potential benefits. Here are some key strategies:
Proactive tax planning and cash flow management are crucial for RSUs due to their complicated tax nature. The vesting of shares and subsequent sale generates ordinary income and capital gains and/or losses. Tax withholding, tax projections, and estimated tax payments should be reviewed often, as well as other tax-minimization strategies such as tax-loss harvesting.
RSUs and other equity compensation can represent a significant portion of an employee's compensation and overall wealth, and create several wealth events during employment with a company. It's essential to maintain a well-diversified investment portfolio as overexposure to a single company's stock can heighten risk and volatility, potentially jeopardizing long-term financial goals. To maintain proper diversification given your unique situation, periodically selling vested shares and reinvesting the proceeds into a diversified portfolio can help improve diversification and mitigate risk.
RSUs should be included in an overall financial plan and aligned with an employee's individual circumstances and objectives. Whether the goal is retirement planning, funding education expenses, or achieving other milestones, a comprehensive strategy that incorporates RSUs can help maximize their potential benefit.
Estate planning is also a key consideration for those holding RSUs. Plan documents will describe the rules regarding life events such as retirement, death, and disability. It’s also important to understand your state’s property laws as RSUs and equity compensation might be deemed marital property in a divorce.
Speaking of state laws, if you move to a new state during a vesting period and later realize income from your equity comp, it’s possible your new state of residence AND your old state of residence will want to tax the income. Each may say they are entitled to a share of the income dependent on how long you lived in the state during the vesting period. If you have equity compensation and move to a new state, make sure you speak to a tax professional who is competent in this area of taxation to help mitigate double taxation statutes.
Conclusion
Restricted stock units represent a powerful tool for aligning employee and employer interests, fostering long-term commitment, and incentivizing performance. They can also provide employees with the opportunity to generate substantial wealth and achieve financial goals. Although RSUs can provide great opportunities, it’s essential to thoroughly understand their mechanics, tax implications, and strategic considerations to maximize their potential benefits.
By embracing a proactive approach and integrating RSUs into a well-diversified personal financial plan, employees can unlock the full potential of these equity incentives. If you have questions or concerns about your equity compensation, consult with a financial advisor who can help you develop a tailored strategy that incorporates your holdings with your overall financial plan.
Tad Jakes, CFP®, EA, ECA