It’s been a little while since we’ve covered the basics of restricted stock units (RSUs), and it’s worth returning to, especially since they have only gotten more popular with companies over time. So, here’s a quick refresher (or introduction), including a recent update, key issues to be aware of, and decisions you’ll need to make in managing this form of equity.
RSUs are just one of the many types of equity compensation, a broad category of employee pay that includes stock options, employee stock purchase plans, restricted stock, stock appreciation rights, and others. Like all forms of equity compensation, companies give RSUs to employees to align employee interests with shareholders’ interests in rapid growth and remaining innovative in competitive industries. RSUs have gained in popularity because of their simplicity for employees and employers. Both publicly traded and private tech companies offer RSUs up and down their employee roster.
How RSUs Work
An RSU is a promise by your employer to transfer shares of company stock to you when certain conditions (the most common being time) have been met. RSUs are said to “vest” over time, meaning that shares are transferred to you as time passes. RSUs typically vest monthly or quarterly for three to five years with a one-year “cliff.” A one-year cliff means that either 12 months or four quarters of vesting complete all at once at the end of the first year. For example, an RSU that vests quarterly over four years with a one-year cliff will be 25% vested at the end of one year and will then vest one-twelfth of the remaining amount each quarter over the next three years.
Once your RSUs vest and the company exchanges your units for actual shares of company stock (usually at a 1:1 ratio), you own the shares and can sell them. If you leave the company, you lose any unvested units. Most companies have trading windows during which you can sell shares—those windows are designed to protect employees from running afoul of insider trading laws. Be sure you are aware of your company’s trading windows when making plans to sell your shares.
The value of your RSUs is simple to calculate. Multiply the number of units by the current price of the company stock (assuming a 1:1 conversion ratio, which is typical). Your online company stock plan account will usually show you the value of your vested shares and unvested RSUs. As long as the stock price is above $0, RSUs will have value—one of the reasons they are popular with employees. In contrast, stock options can be worth nothing if the stock price falls below the option’s exercise price.
How RSUs Are Taxed
RSUs are not taxable when they are given to you. They only become taxable as they vest, and stock is delivered to you. The market value of the shares you receive is taxable to you as ordinary income and is reported on your pay stub in the pay period you receive shares. RSU income is also reported on your Form W-2 at year-end. In addition to being subject to income tax, income from RSUs is subject to federal and state payroll taxes, including Social Security and Medicare.
When you receive shares from vested RSUs, your cost basis in the shares for tax purposes is either their market value on the day they vest or the day you receive them, depending on the specific facts and circumstances of the company’s process for transferring shares. There can be a delay of a few days to weeks between the time RSUs vest and when shares are delivered to your account. Taxation after you receive your shares follows the normal rules for gains and losses on investments. If the stock price goes up after you receive shares, and you sell before one year, the gain on that sale will be taxed as short-term capital gain at the higher ordinary income tax rates. If you sell after one year, the gain will be taxed at the lower long-term capital gains tax rates. Be careful to properly report cost basis on your tax returns for RSU shares you sold to avoid paying tax twice.
Your company is required to withhold income taxes on your RSU income just as it does for your regular salary and bonus income. Because you receive shares, though, there isn’t any cash available for the company to withhold taxes from. To get around this problem, most companies either withhold some of your shares to pay taxes or automatically sell some of your shares to pay income taxes.
RSU income is considered “supplemental wages” for federal income purposes. The rules for supplemental wages require that companies withhold tax at different rates based on the amount of income:
Above $1 million: 37% federal withholding
Below $1 million, either
22% federal withholding, or
supplemental wages are added to regular wages, and the regular wage withholding rate for the combined income is used.
Many companies use the 22% federal income tax withholding rate, and as a consequence, many employees are surprised by a large tax bill when they file their tax returns. They have to make up the difference between what was withheld by the company and the tax they actually owe, which is often higher.
One recent innovation for RSUs granted by private companies is that a second vesting condition is added to work around a tax problem. Because employees are not able to sell their shares in a private company to pay taxes as RSUs vest, the RSU is modified to not vest until both the time-based vesting condition is met and the company has a liquidity event, such as an initial public offering, merger, or acquisition. RSUs with the added liquidity event vesting condition are often called “double-trigger” RSUs.
What You Need to Do
To manage your RSUs well, you’ll need to:
Accept your RSU grant. The day your company gives you RSUs is the award date or grant date. Information about your RSU grant is typically available through the company’s stock plan website operated by a brokerage firm. Your company will ask—and may require—that you “accept” your RSU grant. By accepting your grant, you instruct the company how you would like required taxes withheld.
Keep an eye on tax withholdings. As your RSUs vest and the company withholds income taxes, keep a running tally of how much tax you will owe at year-end. The tax withholding rate the company uses may not be high enough for your situation, resulting in a big, unexpected tax bill.
Decide when to sell your shares. It’s important to know there is no special tax treatment for holding RSU shares, in contrast to what you might be familiar with for incentive stock options. Once you receive the shares in your account, you’ve already paid the tax you owe up to that point (unless not enough tax has been withheld). There is no advantage to holding RSU shares for tax purposes at the time you vest and receive shares.
What this means is that your decision to sell your RSU shares once you receive them is not driven by tax considerations—it’s purely an investment decision. By holding the shares, you’re deciding to invest in the company. Another way to think about it is to assume you received an equivalent cash bonus, which would be taxed in exactly the same way. Would you use your cash bonus to turn around and buy company stock? It’s the same question with RSU shares. Remind yourself to make an intentional investment decision about whether you want to continue holding RSU shares each time you receive them by considering all of your other financial and investment goals. For example, if you have a large portion of your net worth tied up in company stock, you may decide to sell your RSUs to invest in a less risky, diversified investment portfolio you are building for retirement.
Even with the relative simplicity of RSUs as compared to other forms of equity compensation, there are still important issues to be aware of and decisions to be made. It’s important to monitor your RSUs and actively manage them to make the most of this increasingly common form of compensation.
Parkworth Wealth Management provides holistic wealth management services including financial planning, equity compensation planning, investment management, tax planning, and others, on a fee-only basis and as a fiduciary, acting in clients’ best interests. If you want to understand how ongoing tax planning and equity compensation planning can help you build net worth and avoid tax reporting mistakes, schedule a complimentary consultation.
