Restricted Stock Units (RSUs) are a popular form of equity compensation at many tech companies like Intel, Apple, Microsoft, or Amazon. They can, along with other types of equity compensation, add up to a significant portion of one’s income each year and become a substantial part of one’s net worth over time. So, it’s crucial to understand how they work, how they are taxed, and have an investment strategy in place for managing your RSU compensation.
- RSUs are a popular form of stock compensation which are taxed as income as they vest.
- Shares held after vesting are taxed as capital gains when they are sold.
- It’s important to periodically manage your company stock to prevent concentration risk and income/career risk.
- If you are an executive or insider, take care to follow company and SEC guidelines when buying/selling company stock.
Let’s dig in.
What Are RSUs And How Do They Work?
RSUs or Restricted Stock Units are a popular form of equity compensation. The two key dates for RSUs are the grant date (when a company promises “restricted” shares of stock to employees) and the vesting date (when the shares are no longer “restricted” and become owned by the employee). RSUs are taxed as income at vesting with shares typically vesting in tranches over a period of time—four years is common.
For example, your company may grant you 1,000 shares in 2020, a quarter of which vest each year over the next four years (e.g., 250 shares in 2021, 250 shares in 2022, etc.).
Most vesting schedules are time-based with equal vesting over a 4-year period (like in the example above), common. However, other vesting schedules exist. A quick overview:
Types of RSU Vesting Schedules
- “Graded” Vesting Schedule: RSU vest periodically over a series of years. Could be equally or according to another schedule (i.e., 40% in year 1 and then 20% in each of the next 3 years)
- “Cliff” Vesting Schedule: 100% of your RSUs vest all at once. This Cliff could be triggered after a specific period of service or tied to achievement of company or individual performance
Separation from your employer almost always stops vesting although some employers will offer an acceleration of a year (or more) of vesting as part of severance or retirement packages (or potentially in the case of death or disability).
How RSUs Are Taxed
Compared to other forms of equity compensation, the tax treatment of RSUs is pretty straightforward. However, it’s still important to understand and manage it appropriately. (For a deeper dive into RSU taxes and how to combine RSU income with other strategies to reduce your tax bill, see this post.)
RSUs are almost always taxed as income to you when they vest. If the shares are sold immediately, there is no capital gain and the only tax you owe is on the income. However, if the shares are held beyond the vesting date, any gain (or loss) is then taxed a capital gain (or loss).
The tax treatment of RSUs is no different than if you were to receive a cash bonus (on the vesting date) and then use that cash to buy your company’s stock.
- Tax at vesting date is: # of shares vesting x price of shares = Income taxed in the current year
- Tax when shares are sold (if held beyond vesting date) is: (Sales price – price at vesting) x # of shares = Capital gain(loss)
- 1,000 shares vest in June of 2020
- The share price is $10 on the vesting date (this becomes your cost basis if holding the shares)
- You owe taxes on $10,000 of RSU income for 2020
- If the shares are held for two more years, then sold for $30 per share you will have a $20,000 capital gain ($30 – $10 x 1,000 shares)
As mentioned above, at vesting, you are subject to tax and withholding on the shares, which includes federal, Social Security, Medicare, state, and local taxes. Your company may offer you a choice for how to pay the tax, or it may have a mandatory method. The ways to cover the tax are:
- The most common method is for the company to “tender” the number of shares needed to cover the withholding tax.
- You could fund the withholding out of pocket and hold 100% of the vested shares.
- Or, all the vested RSUs could be sold, essentially turning it into a cash bonus tied to the price of your company’s stock.
It’s important to note that even if you have a capital loss on the shares, you will still owe income tax based on the price at vesting. In an extreme example, when a company stock goes to zero, the amount you are taxed on as income equals your capital loss. But as income is taxed at higher rates than capital gains (losses) in most cases, you would end up losing money on your “bonus.”
RSUs vs. Stock Options
Unlike stock options, RSUs are almost always worth something even if the stock price of your company falls. For example, 1,000 RSUs at a company whose stock fell from $20/share to $10/share is still worth $10,000 versus potentially nothing with options.
However, with options, the advantage (or disadvantage) is the built-in leverage. Under RSUs the difference between a stock price of $10 and $30 on 1,000 shares is $10k to $30k. However, this same range with 10,000 options (with a strike price of $18 as in the example above) results in a difference in value to the employee of $0-$120k.
Incorporating RSUs Into Your Investment Strategy
Think about it this way: If your company gave you a cash bonus, would you use that cash bonus to buy your company stock?
If the answer is “no” you should probably sell your shares when they vest and reinvest the proceeds in a well-diversified portfolio.
Because of the increased risk of investing in individual companies, the vast majority of which will end up underperforming the market, it typically doesn’t make investment sense to hold onto the shares. Research by Longboard Asset Management revealed that from 1983-2006, nearly 2 in 5 stocks actually lost money (39%), almost 1 in 5 lost at least 75% of their value (18.5%), and 2 in 3 underperformed the Russell 3000 index.
Now, it’s understandable to want to benefit from the potential success of your company, but this should be limited, as a rule of thumb, to around 10% and no more than 20% of your net worth. Remember that not only do you have risk in the stock, but you also have career risk as well. If things go poorly at your company, not only does your stock and net worth get hit, but you might be out of a job and a paycheck at the same time.
However, if you did hold on to your RSUs and are fortunate to have capital gains (good for you!), taxes may now act as a barrier to diversifying. Is there anything to do? A couple of ideas:
- If you have appreciated RSUs but aren’t maxing out your tax-deferred accounts (401(k), IRA, or HSA), your RSUs can be sold to fund these contributions and to diversify your portfolio. These pre-tax contributions can help reduce your tax bill that was just increased by realizing the capital gains.
- If you are charitably inclined, these shares can be allocated to a Donor Advised Fund, which can then be diversified and used to fund future charitable giving.
If you are a company executive or considered an insider with access to material, non-public information, take care to execute any liquidation or diversification strategy within your company’s and SEC guidelines. The two key guidelines are:
- A Trading Window: The period set by the company in which they allow executives and insiders to trade the company’s stock.
- A Rule 10b5-1 trading plan: A prearranged program for periodic purchases or sale of company stock that meet SEC criteria and avoid insider trading violations.
In summary, RSUs are a valuable piece of tech employee compensation plans. Make sure you are armed with the knowledge to make the most of them, and as always, if we can be of any help, schedule your free consultation here.