What Is the RSU Tax Rate?
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When working for a boss, there are far more exciting remuneration options than a monthly salary. Some companies will offer On Target Earnings (OTE) incentives or bonus schemes. Most of these are linked to personal performance as expressed as a function of meeting goals and targets. The downside of these options is that they elicit unwanted behaviors such as gamesmanship or sacrificing longer-term growth for short-term gains.
A good option to shift the focus away from the individual and short-term thinking is by offering equity in the form of stock shares in the company. The benefit of these forms of compensation is that these types are inherently more beneficial over a longer period of time. By removing the individual metric linked to goals and targets and taking overall company value into consideration, actions to enhance remuneration are shifted from the individual to the company as a whole.
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Equity as Part of Financial Remuneration
In most cases, this type of equity is offered as a Restricted Stock Awards (RSAs) or Restricted Stock Units (RSUs). The restricted element means that these stocks will follow a vesting schedule, a scheme in which stock shares are earned over time. Typically you can consider shares vested when the employee “fully owns” them and unvested when they are set to be “fully owned” at a later date. There are significant differences between RSAs and RSUs, which also impact the way tax needs to be paid on both.
What Are Restricted Stock Awards?
RSAs are usually involved when someone is an early employee. Typically RSAs are granted before any equity financing round. Startups usually don’t have much financial room to attract top-tier talent, and by adding RSAs, they can be competitive in the hiring market, granted there is a high-risk, high reward factor involved for the employee. In most cases, these RSAs are offered at Fair Market Value (FMV), a discounted FMV, or sometimes even free.
The employee owns the stock shares at the moment they have been granted, but vesting may dictate they are bought at a later date. Vesting restrictions are usually in place to ensure that a company can buy back shares if the employee leaves shortly after joining.
It does mean, however, that the shares are issued and kept aside for the recipient. In most cases, the recipient will already get the voting rights associated with the share ownership. On top of that, the recipient will receive any dividend, including on unvested shares.
What Are Restricted Stock Units?
RSUs are used at more mature phases of a company. As the company is worth more than it was at startup, offering RSAs would not make sense or be possible. RSAs are owned by the employee at the grant date; RSUs follow the principle that stock will be delivered at a future date, contingent on the vesting schedule, a specified date, or a liquidation event. RSUs are also granted at no cost to the employee as opposed to RSAs, which need to be “purchased.”
It’s important to consider that RSUs are not issued at grant but represent a commitment to do so at a later date.
This also means that unvested RSUs will not come with voting rights or dividend payout. Some RSU agreements might include equivalent options to dividend payout for unvested shares.
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How Does Termination or Leaving a Job Affect RSAs and RSUs?
If an employee leaves the company, this will affect shares acquired via RSA or RSU. As RSAs are immediately granted, it’s important for employees with RSAs to consider the stipulations in the vesting schedule.
For example, shares will become vested as time goes by, reducing the amount of unvested (what the company can buy back). In most cases, the employee will keep a certain amount of shares depending on the duration of employment and stipulations in the vesting schedule.
RSU recipients usually are at risk of losing shares. As the vesting schedule only grants shares if certain prerequisites have been met, it's entirely possible that RSUs expire before conditions are met.
Ordinary Income Tax and Capital Gains Tax on RSAs and RSUs
As with any equity compensation, it’s important to consider tax. Whenever a company pays an employee, be it in salary, benefits, or equity, there is tax to pay. There are two types of tax to consider: ordinary income tax and capital gains tax. Capital gains tax is generally lower than the income tax. It’s important to fully understand how RSAs and RSUs are taxed, which is not an easy task, but essential to potentially save thousands of dollars.
Tax Liability for Restricted Stock Awards
RSAs are owned at grant, but actual value exchange only happens according to the vesting schedule. Only when shares are vested, the employee will be subject to tax. This means that any gains on the FMV made between grant and vest date are not applicable.
The employee will have to pay tax on the value of the shares as ordinary tax income accrued in the tax year of acquiring the shares. Subsequently, any value gain between vest date and sale of shares will be subject to capital gains tax.
Section 83(b) election
As mentioned above, there might be some time between shares being granted and the actual vesting date. When there is a substantial time between grant and vest date, FMV can grow substantially.
This is where section 83(b) election offers the option to reduce the tax paid. If an RSA recipient “elects” to pay ordinary income tax upfront on FMV on the day of grant, most likely, the tax will be at its lowest point. This has to be done within 30 days of the grant date. Any future sale of the shares will not be the value difference between FMV at the grand date and the date of sale.
This will be a larger gain versus paying tax on vest date but considering that capital gains tax is lower, this will be a substantial tax reduction for the RSA recipient.
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Tax Liability for Restricted Stock Units
Taxation of RSUs follows a more straightforward route than RSAs. As the recipient only gets the shares at the vesting date, the recipient will have to pay ordinary income tax for the value received.
Also, whereas with RSAs, the income tax is issued on the difference between grant date FMV and vest date (as RSAs are bought by the recipient), RSU receivers usually have to pay the full FMV at vest date (as shares are usually given without cost). RSUs will be subject to capital gains tax on the difference between FMV of vest date and sale date.
RSU Tax Withholding
In most situations, your company will withhold tax for your RSUs. In some cases, this will happen at the expense of RSUs without advance notice. It is important for RSU recipients to check how the tax will be processed as other options might be more favorable depending on the personal situation of the recipient. Some RSU receivers might opt to pay for the tax owed via personal check or would prefer the tax withhold via deduction of their paycheck.
RSU Tax Rates
At any rate, RSUs are seen as supplemental income. Most companies will withhold federal income taxes at a flat rate of 22%. The value of over $1 million will be taxed at 37%. This doesn’t include state income, Social Security, or Medicare tax withholding. In some states, such as California, the total tax withholding on your RSU is around 40%.
It’s important to understand the amount withheld on (future) RSUs to avoid hefty tax charges afterward or even penalties. If the RCU recipient suspects being far under the expected tax withholding, it would be wise to adjust the W-4 or make quarterly estimated tax payments. RSU tax recipients should consult a tax specialist if they are unsure of their taxes.
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In short, RSAs are usually more attractive from a taxation perspective as there are options to cover most of the value gain under the capital gains tax. RSUs are typically taxed under ordinary income tax, making it less attractive from a taxation perspective. As with many things, RSAs and RSUs follow the rules of risk and reward.
If a highly skilled person joins a startup for below-market value compensation, it will have to be at the promise of reward. This is why RSAs offer far better value when things pay off, including more profitable tax options. Obviously, it’s not common to find promising startup options waiting to hire people. RSUs are a great option for professionals that have a lower risk appetite but are still at the stage in their career where a salary-only option is no longer a necessity. Being able to include capital benefits as part of the remuneration is a great way to build substantial wealth.
RSAs and RSUs can be complex and opaque; if there is any uncertainty, it would be wise to consult a financial advisor and tax consultant to ensure the recipient knows what’s in it for them and how to deal with taxation.