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Restricted stock units (RSUs) are used as supplemental compensation for employee benefit packages. While it is beneficial and even motivating to be given stock in your company, there are many factors to consider. It’s important to understand how RSUs will affect your financial plan for both investing and taxes. One wrong decision could result in losing stock value, owing tax payments or being off track for your retirement plans. This article will discuss the five things you need to know about your restricted stock units and tax withholding options.
#1. Restricted Stock Units (RSUs) are a way your company can compensate you with stock
Restricted stock units refer to employee compensation linked to a company’s stocks. A restricted stock unit is actually a promise to issue one stock for every unit granted to an employee if they meet certain conditions. After meeting these conditions, RSUs are said to vest and the company issues the promised stocks.
Most tech companies like Tesla, Google, and Amazon use RSUs to attract and retain top talents. These companies also use RSUs to align employee interests with the company’s goals. Since the potential stock price value of RSUs depends on the fair market value of the company’s stocks, this type of compensation motivates employees to do their job well.
By granting RSUs, the company can offer incentives to employees without paying them anything since RSUs are worthless until vesting.
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#2. It is very important to understand the vesting schedule of your RSUs
Vesting plays an important role in RSUs. RSUs do not have any value to you until it vests.
Vesting refers to a condition which may be related to performance such as reaching a sales or income quota, remaining for a specified number of years, or both.
For instance, a company may grant 600 RSUs with a three-year vesting schedule. On the grant date, these RSUs have no value. At the end of Year 1, a third of the stocks or 200 RSUs vests and become actual stocks.
If these RSUs have a market value of $10 on the vesting date, you will report income of $2K (200 multiplied by $10). Since the RSUs are already stocks issued under your name, you can convert the stock to cash, sell or hold them. If you resign after the first year, you will forfeit the remaining 400 RSUs but you can keep your 200 shares.
Most companies have a four-year vesting with a one-year cliff. The cliff means that you can only receive 25% of your RSUs at the end of Year 1. After the first year anniversary, vesting could happen monthly, quarterly, or semi-annually thereafter.
If you prematurely cash out before your vesting date, you will be required to pay tax on that amount, plus additional penalties if you don't pay enough in taxes withheld.
#3. RSUs become part of your taxable income at vesting
When RSUs vest, they become actual stocks which are reported as part of your compensation income. Your RSU compensation will be based on the market price of your company’s stock on the vesting date. From the example above, your total compensation RSU, which is subject to tax, would be $2K since the 200 shares that vested were valued at $10 on the vesting date.
This income will be reported in box 1 of your Form W-2 and is subject to ordinary income tax. Income from your RSU compensation is also subject to applicable state and local taxes.
If you live in a high-income tax state like California where the highest income tax rate is 13.3%, your tax due on your RSU income could be as high as 50%!
Since RSUs are considered supplemental income, the required withholding taxes are also different. If your supplemental income is less than $1M, your employer will withhold 22% of your income. Over $1M, withholding tax will be 37%.
To help you pay for these taxes, some companies allow you to “tender” some or all of your shares to cover withholding taxes. This means that you will surrender the shares back to the company to pay the tax. This way, you don’t have to pay for the taxes with your personal funds. Take note that withholding tax will be due a month after the vesting date.
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#4. You will also pay capital gains tax when you sell your RSU shares
After vesting, your RSU shares become yours. If you decide to sell your RSU shares, and the selling price is higher than the fair market value of your stocks, you will be liable for capital gains tax. You can calculate capital gain by deducting the market value of your RSU shares on the vesting date from the selling price.
For instance, you sold your 200 shares above which were valued at $10 on the vesting date at $15. Since the selling price is higher than your stock’s market value, there is a long term capital gain of $5 per share ($15 less $10). This means that you owe taxes on the $1K ($5 multiplied by 200 shares) capital gain.
If you sold your shares less than one year from the vesting date, you need to report short-term capital gains. This means that the income of $1K will be subject to ordinary income tax rates.
If you decide to hold the stocks for more than a year from the vesting date, capital gains will be subject to long-term capital gains tax rates. The highest bracket for long-term capital gains tax is 30% but applicable taxes will depend on your income bracket.
Any gain or loss from the sale will be reported on Form 1099-B which would typically be given to you by your broker. You also have to report the sale on Form 8949 and Schedule D of your annual tax return.
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#5. It might not be a good idea to hold onto your RSUs forever
Once your RSUs vest, you have the option to sell the shares right away or hold them. Selling your shares is usually not a problem since most companies offering RSUs are publicly traded. Moreover, most companies have a tie-up with a brokerage where you can sell your shares. In most cases, it would be better to sell your shares once they vest.
The future is always uncertain. Even if your company is doing well at present and you expect stock prices to climb higher, you can never be sure. If you hold the stocks for years and prices drop, you have no choice but to sell your sales at a loss.
Among the biggest risks in holding RSU shares is overexposure to your own company. Since your company pays your salary, you are already susceptible to changes in your company’s performance. If there are issues with your company, your employment will not just become uncertain, you will suffer additional losses when stock prices drop.
The only way to avoid exposure to a company-specific risk when investing is diversification. If you hold the company shares and they make up more than 10% of your net worth, you should rethink your investment strategy. Anything over the 10% mark makes you susceptible to risk.
When assessing your exposure to your company stocks, don’t just think about RSUs, consider ESPPs, stock options and other equity-based compensation you receive from your company.
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There are many factors to consider if your employer is compensating you with restricted stock units (RSUs). Talk with your human resources department to see how much stock you are being issued per unit and what the vesting schedule is. If you plan on leaving the company within a short period of time, you may be compensated little to nothing of that stock.
You will also want to look into how the vested stock will affect your taxable income. It could potentially put you into the next tax bracket if you are on the edge between two. Speak with a CPA about this, as well as how the timeframe for selling the stock could affect how you pay taxes.
Additionally, analyze the risk you are taking on with restricted stock unit plans. Make sure that you have a diversified portfolio with less than 10% of any one company. Understanding your employee benefits can help you to make educated decisions on your financial situation. If you need assistance selecting which investment options are right for you, be sure to speak with a financial planner or tax professional.