(6 minutes to read)
We receive this question quite often, and it’s a fun one, because it’s really an investment question masquerading as a tax question. Let’s break down why.
RSU tax withholdings
When your restricted stock units (RSUs) vest, the company is required to withhold and pay taxes on your behalf. That’s because the value of the RSUs that vest is taxable compensation income to you, just like a bonus. When you receive a cash bonus, the company must withhold taxes from your paycheck for the bonus income. It’s the same with RSU income.
The company must withhold for federal and state income taxes, payroll taxes (which pay for the federal Social Security and Medicare programs), and possibly other state and local taxes as well, such as New York City income tax or California state disability insurance.
Federal and state income tax systems in the US are “pay as you go” systems. You are required to pay tax on your income as you earn it. Withholdings from your paycheck, and in this case from your RSU income, help ensure you are paying enough tax throughout the year. If you don’t pay enough tax during the year, you may be charged with penalties and interest.
The amount to be withheld from your salary or wages may not be set correctly. We’ve all had the experience where our withholdings were set a little (or a lot!) too high or too low, and we overpaid or underpaid tax during the year. The difference between the tax you owe and what you’ve actually paid during the year gets calculated on your federal and state income tax returns, and you pay the difference. That’s the amount of tax “refund” you receive or tax you “owe” when you file your tax returns. It’s really just the true-up calculation of the difference between what we owe and what we paid during the year. So, if you don’t want to owe tax during tax time, make sure your withholdings are set properly.
RSUs make this a little more challenging, since there is a special problem with withholdings on RSU income. RSU income is “supplemental” income in tax-speak. The rate at which tax is withheld on supplemental income, including RSU income, is fixed by law. It’s often the case that the withholding rate on your RSU income won’t match your actual tax rate, resulting in over- or under-withholding. If too much tax is withheld, it’s not a big problem—you’ll just get a bigger tax refund when you file your tax return (and the government will have your money until then and not pay interest on it). If not enough tax is withheld, you may be scrambling at tax time to come up with enough cash to pay your tax owed, and you may have to pay extra in the form of penalties and interest. In order to avoid under-withholding penalties on RSU income, you may need to adjust your regular pay withholdings, or make estimated tax payments during the year.
Cash option for paying taxes
Many companies offer employees a choice of methods for paying required tax withholdings on RSU income. Common methods include:
Sell to cover. Some of the delivered RSU shares are sold and the proceeds of the sales are used to pay the required income, payroll, and other tax withholdings.
Net settlement. Some of the shares to be delivered to you are instead delivered to the company, and the company pays the required taxes.
Pay with cash. You give the company cash by electronic funds transfer or check, and the company pays the required taxes.
Paycheck deduction. The company deducts enough cash from one of your regular paychecks to pay the required taxes on your RSU income.
Most companies seem to offer two or three, but usually not all, of these options.
An important point here is that there are no tax-saving opportunities available based on what option you choose. How you pay does not affect how much you pay.
People often get confused on this point. With RSUs, you will have already paid all the tax you owe on the shares that vest through withholdings (and possibly estimated tax payments to make up for the under-withholding problem mentioned above). Going forward, your tax on the shares will be determined according to the normal short-term and long-term capital gain rules. (See this important article on capital gains tax rules for RSUs, and how to avoid paying double tax.)
Deciding which tax payment option is best
None of these payment options will minimize your tax bill, but there are other differences. With the first two choices above, you are paying tax with the RSU shares themselves. After you hand over shares to pay the required tax withholding, you have less shares of your company’s stock.
With the last two choices, you are paying with cash from other sources, either your bank account or income you earned that the company hasn’t paid to you yet. You keep all the shares that vested.
When paying taxes with cash (the last two options), you still have the shares, and you can decide what to do with them. You can turn around and sell the shares to replenish the cash you paid for taxes, or you can hold the shares.
While preserving the option to decide what to do with the shares later might be valuable, if you’re going to sell the shares anyway to backfill the cash you paid for taxes, it’s a lot of extra effort to ultimately wind up in the same place as you would have if you had used one of the first two payment options. This effort is in addition to still needing to check if you are under-withholding and potentially need to make estimated tax payments. For more on this, see our checklist for managing your RSUs.
So, if there is no tax advantage to any of the withholding tax payment choices above, the real question is whether there is any benefit to holding more shares of the company stock. And at its heart, this is an investment question. If you believe the stock will be increasing in value, you may want to hold more of it.
Again, there is no tax advantage to holding the stock once it vests (assuming we’re talking about a public company, not a private company). Rather than holding shares from your RSUs that vested (that you would otherwise use to pay taxes), you could sell to cover or use net settlement to pay required withholding, and then go into the open market and buy more shares with the leftover cash. There is no advantage either way. You can wind up with the same number of shares and the same amount of cash. With RSU shares that vest, you don’t receive a discount on the purchase price of the shares like you might in your employee stock purchase plan (ESPP). It’s simply that you used some of your cash to own extra shares.
The key question then is how much you should be investing in your employer’s stock. There are several factors to consider here, including general principles of diversification, what percentage of your net worth is tied up in the company stock, and your view on the company’s prospects going forward. The conclusion you draw will depend on your unique financial situation. For a more in-depth discussion of these factors, see our earlier article on the investment and financial planning considerations around deciding whether and when you should sell RSU shares.
Our default recommendation for vested RSU shares is to sell all the vested shares immediately, using sell to cover or net settlement to pay the tax, and treat the net after tax proceeds just as you would a cash bonus. From there, make a new decision about how you want to invest the cash, either back into your employer’s stock, or more typically, by moving the new cash to your diversified long-term investment portfolio.
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 help properly managing your RSUs and using them to build wealth, schedule a complimentary consultation.
