What You Need to Know About Restricted Stock Units

Restricted stock units (RSUs) are a great compensation bonus that employers can potentially give their employees. They reward employees that remain with a company. They can be a very valuable form of compensation and offer several planning opportunities. But if you're not familiar with exactly how they work, or what the planning opportunities are, you might be wondering what to do with your RSUs. The key things to remember are the income tax consequences and the potential to build up a fairly risky portfolio. While there is nothing wrong with concentrated positions in company stock, it is important to be aware of the risks.

Through RSUs, a company gives ownership to its employees. It can be a win-win for both the company and employees. Longer employment typically leads to more productivity, which leads to the company being more profitable and the employee participating in those profits. (For related reading, see: Employee Stock Options: Introduction.)

Grant Date vs. Vesting Date

RSUs have two main dates that recipients should be aware of. The first is the grant date. The grant date is when your company pledges shares of the company to you with the promise to give these shares to you at a further date, the vesting date. Some shares are restricted, which means they are subject to a vesting schedule and you can't actually do anything with the shares until they've vested. The vesting schedule is commonly based on length of employment, or performance goals.

The stock could potentially all vest at once, or a percentage could vest over a period of years. The date that the shares vest is the basis used for computing tax consequences. It's treated just as if you had bought a stock on that date in terms of computing tax when the stock is eventually sold. Keep in mind that on the vesting date, the market value of the shares is included as part of your income.

Tax Considerations

Let's use an example to illustrate the tax implications of vested RSUs. On July 1st, 100 shares of a company's stock vests. On this date, each share is worth $50. The total market value of these shares is then $5,000 (100 shares x $50 = $5,000). The $5,000 must be included as ordinary income on the recipients W-2 form. The compensation is subject to withholding taxes such as Social Security, Medicare, and state and local taxes in addition to federal income taxes. Your employer may or may not give you all or a few of the following options to pay withholding tax on the vested shares: 

  • Cash transfer: Use cash to pay the withholding tax. No shares are sold.
  • Sell to cover or net issuance: Both involve selling vested shares of stock to cover the cost of the withholding tax. Remaining shares are given to the recipient.
  • Same day sale: Sells all vested shares and uses part of cash proceeds to cover withholding tax. Remaining cash is given to the recipient.

There isn't a cookie cutter solution to choosing what to do with your RSUs on the vesting date. While nothing can be done to avoid this inevitable tax on the RSUs, the good news is the shares are now 100% yours. (For related reading, see: How Restricted Stock and RSUs are Taxed.)

The last tax consideration to be aware of now that you own the stock is what happens when you sell it. If the stock is sold prior to one year after vesting, the gain (increase in value since vesting) will be taxed at ordinary income tax rates (your income tax bracket). If held for longer than one year, the gain will be taxed at the more favorable long-term capital gains rates (0%, 15% or 20% depending on your income tax bracket).

Planning Opportunities for RSUs

The most common question RSU recipients have is, Should I hold, sell or diversify my stock? In an attempt to answer this question, please keep in mind every person's situation is different and several factors must be considered. You may consider holding your vested shares of company stock if you believe the company is on a growth trajectory. The first company that comes to mind is Amazon.com and it's massive growth over the past 20 years. Employees who decided to sit on their stock in the early years have more than likely become very wealthy.

However, with any concentrated position, there comes risk. Having "all your egg's in one basket" inherently increases the risk you are taking with your investments. While you may think that an investment is less risky because you know the company and you work there, it doesn't change the fact that concentrated positions involve more risk than if you're diversified. If RSUs are continually being granted, you may consider selling a portion of the stock and diversifying elsewhere, knowing that you'll be receiving more company stock in the future.

If you decide to hold company stock, remember gains are taxed at better rates if the stock is held for longer than a year. For example, if you have stock you've held for nine months that has appreciated in value by 15%, that 15% gain will be taxed at your ordinary income bracket if sold. If you waited an additional three months to sell the stock, the 15% gain would be taxed at the lower long-term capital gains bracket, potentially saving a lot of money in taxes.

Secondly, you may decide to sell the vested company stock immediately, or shortly thereafter. This could be a consideration for the mere fact of diversifying, or potentially to store up on cash for liquidity. Because nothing can be done about the income taxes paid on RSUs, if you sell immediately the short-term capital gains will be very minimal if nothing at all, and the proceeds could be used for other financial goals like buying a home, funding a 529 plan or a Roth IRA.

Be Aware of the Risk

RSUs are a great compensation bonus. The key things to remember are the income tax consequences and the potential to build up a fairly risky portfolio if the stock continues to accumulate. While there's nothing wrong with concentrated positions in company stock, it is important to be aware of the risk. (For related reading, see: 10 Tax Tips for Stock Options.)

 

Disclosure: Please consult with a tax advisor for tax advice. This article is for educational purposes only.