Key Points:
- RSUs and RSAs: RSUs are promises to grant shares or cash upon vesting, while RSAs are actual shares with restrictions.
- Dividends: RSAs mandate dividend payouts, whereas RSUs offer optional dividend crediting.
- Voting Rights: RSAs provide voting rights even during the vesting period, unlike RSUs.
- Section 83(b) Election: Available for RSAs for potential tax benefits but not an option for RSUs.
- Tax Implications: RSUs are taxed at vesting, while RSAs offer more flexibility with Section 83(b) elections.
Introduction
Restricted Stock Units (RSUs) and Restricted Stock Awards or Grants (RSUs and RSAs) are now common forms of equity compensation, especially in corporate packages. They usually form part of a company’s Long-Term Incentive Plans (LTIPs), designed to align your compensation with the interests of the company and its shareholders.
RSUs and RSAs award types share similarities, but they also have key differences. For the sake of simplicity, this discussion will focus on RSUs, which have gained popularity because they only require the company to offer voting rights or dividend payments once the shares are officially transferred to you.
Both RSUs and RSAs serve as compensation, allowing you to earn a set number of company shares based on specific conditions. Unlike stock options, which give you the right to buy shares at a predetermined price, RSUs hold value unless the company’s stock value drops to zero.
RSUs usually come with a vesting schedule or performance milestones. This setup ensures you receive your shares gradually, fostering a sense of ownership and aligning your interests with the company’s success.
Terms & Example
Grant Date: It all begins on the grant date, which is when the company officially awards you the RSUs. This date might differ from when the company first informs you that you’ve earned the RSUs. The grant date serves as the starting point for your vesting period.
Vesting Period: Most RSUs come with a vesting period; they are usually time-based, defining when you still need to be employed by the company to earn the shares. Since vesting is common in various equity compensation tools, you can find a separate article on this topic to avoid repetition. Refer to that section for more details on vesting.
Tax Holding Period: One crucial point to remember is that the tax holding period starts the day after you receive the shares.
Note: Besides RSUs and RSAs, you might also encounter Performance Share Units (PSUs) and Performance Share Awards (PSAs). These work much like RSUs and RSAs but vest based on achieving specific performance targets, usually Earnings Per Share (EPS).
Example
Let’s consider a scenario where you are granted 1,000 shares, with 25% vesting each year over the next four years. When this pattern continues for several consecutive years, with the vesting percentage increasing each year based on the company’s or your performance, the vesting schedule may begin to take the following form:
When RSUs are delivered (usually on the same date as vesting), the market value of the shares is considered taxable income for the employee. The RSUs’ value at vesting is determined by the stock’s fair market value on the vesting date multiplied by the number of vested shares. Human Resources or your executive compensation team should also send a notice stating the market rate at the time of vesting; it is important to keep this document as it is not always reported to the brokerage or recorded correctly.
The employee’s taxable income for the year includes the vested amount (price x shares). This taxable amount is subject to withholding taxes, including federal income tax, Social Security tax, and Medicare tax. Based on the schedule provided, there will be 1,150 shares that will vest in the year 2024. Assuming the market value of the shares on the date of vesting, this would generate $80,500 of pre-tax ordinary income. If we assume the executive is in the 32% tax bracket, the net amount is:
RSUMarket Value of Stock at Vesting in 2024$70Number of Shares1,150Pre-Tax Gain$80,500Ordinary Inc Tax Rate (Assumption)32%Tax$25,760After-Tax Gain$54,740
Often, employers handle the tax payment on vested RSUs through a “sell to cover” or “sell to cover taxes” method. In this setup, your employer automatically sells some of your vested shares to pay the tax liability from the vesting event. The number of shares sold is usually calculated to cover estimated taxes, including federal (using the supplemental income withholding rate), state, and local taxes, as well as payroll taxes that may be required. While you only receive the net amount after taxes, the total vested value still gets reported on your tax return.
By doing this, your employer ensures you receive the remaining shares net of taxes, sparing you the hassle of managing the tax payment yourself. This method allows you to meet your tax obligations without needing extra cash or selling shares independently.
Here are the steps involved in the sell-to-cover process:
- Calculation of Tax Liability: The employer calculates the estimated tax liability based on the fair market value of the vested shares on the vesting date and the applicable tax rates. Employers typically withhold taxes at the federal supplemental wages withholding rate (22% as of 2023 or 37% for supplemental income levels over $1 million). Note that this percentage may be too low based on your tax situation, and additional taxes may be owed at the end of the year, especially if you have a working spouse.
- Share Sale: The employer sells sufficient shares from the vested RSUs to cover the taxes owed. The shares are usually sold on your behalf by a broker or a plan administrator.
- Withholding Taxes: The employer withholds the necessary taxes from the proceeds of the share sale, including income tax, Social Security tax, and Medicare tax. After deducting the taxes from the income, the remaining amount is held back and then paid to the respective tax authorities.
- Delivery of Net Shares: After the taxes are withheld, the remaining shares, known as net shares, are delivered to your brokerage account or stock plan account. These net shares represent the portion of the RSUs you retain after accounting for the tax liability.
There is one last step if you use a different brokerage house than your company’s designated one, such as having your personal accounts at Etrade while your company uses Wells Fargo. Transferring the net shares from the company’s escrow to your account may involve another step.
In this scenario, after the sell-to-cover transaction, the net shares would be placed into escrow at the company’s brokerage (in this case, Wells Fargo). In the vesting letter or related communication, your company should have provided all the necessary information, including instructions to move the shares. You need to contact the company’s brokerage directly to have the shares transferred from the escrow account into your personal brokerage account (Etrade in this example).
You would typically reach out to the customer service or brokerage support team of Wells Fargo, provide them with the required information and instructions, and request the transfer of the net shares to your Etrade account. They will assist you with the necessary steps to transfer the shares from the escrow account to your designated personal brokerage account.
It’s essential to promptly follow up with your company or the brokerage house to initiate the transfer process. They can provide you with any specific forms, documentation, or additional details required to facilitate the transfer smoothly. Keeping track of the vesting letter or related documents provided by your company will be helpful, as they usually contain the necessary information to initiate the transfer.
It is recommended to inform your company’s HR or stock plan administration team of any changes in your brokerage accounts in advance. This can help ensure a smooth transfer process and accurate record-keeping.
It might seem like it took a lot to get here. However, I promise that after you go through the process once, you’ll find that the company does almost everything for you except for the delivery if you are in an outside brokerage. And after you do that once, it will be so much easier the next year.
Now, with the shares in your account, you become a shareholder and may choose to hold or sell the shares. Additional tax implications are dependent on the decision you make.
Differences Between RSUs & RSAs (RGSs)
Thus far, we have discussed RSUs and RSAs as if they are similar, but they have key differences affecting your financial planning and tax obligations.
RSUs are essentially a promise from your employer to give you shares or their cash equivalent once you meet the vesting requirements. Unlike RSAs, RSUs aren’t actual shares; they’re a commitment to provide shares in the future. RSUs will only offer dividends or voting rights once they vest – not before. Some companies may choose to credit an equivalent value of dividends to your RSU account, but this is optional. If you receive these credited dividends for RSUs or actual dividends from RSAs, they count as ordinary income unless you claim an 83(b) election on your RSAs.
RSAs, in contrast, are actual shares of stock granted to you with certain restrictions, usually tied to a vesting period. Because they’re actual shares, you’re entitled to dividends on your RSAs even during the vesting period. This differs from RSUs in that dividend crediting is not optional, and RSA holders have dividend and voting rights even when their shares are still restricted, giving them an advantage over RSUs.
Tax Strategies for RSUs
Unlike stock options, which allow you more control over when to exercise and incur taxes, RSUs offer fewer tax planning opportunities. RSUs get taxed immediately upon vesting, and your employer handles the income reporting. Despite these constraints, if you’re a corporate employee receiving RSUs, you still have strategies available to manage your tax liabilities and optimize your financial gains.
Section 83(b) election
First, let’s discuss a strategy exclusive to RSAs and RSGs: the Section 83(b) election. This option allows you to pay taxes on the shares’ fair market value when granted rather than upon vesting. The goal is to benefit from any stock appreciation beyond the grant value. With an 83(b) election, if the value of the stock increases, you will be taxed at the lower capital gains rate instead of the higher ordinary income rate.
However, this strategy has its risks. If the stock value declines, you’ve already paid taxes at the ordinary income rate but can only claim losses at the lower capital gains rate. Most risky of all, if you leave the company before the shares vest, you’ll have paid taxes on shares you never actually receive. If this ends up happening, be sure to try to negotiate this cost into a signing bonus.
Opting for a Section 83(b) election could be smart if you expect significant stock appreciation and plan to stay with the company through the vesting period, potentially reducing your overall tax liability and maximizing net realized compensation.
Remember, you can’t make a Section 83(b) election for RSUs, making this an advantage unique to RSAs and RSGs.
Sell Immediately
Opting to sell your RSU shares immediately upon receiving them can be a strategic move. Doing so will classify any gains or losses as short-term capital gains or losses, which are taxed at ordinary income tax rates. Selling the shares immediately minimizes the risk of holding a concentrated position in company stock and provides cash liquidity. This strategy allows you to take advantage of the RSU compensation promptly while mitigating potential price fluctuations in the short term.
Hold and Diversify
Opting to hold the shares creates potential tax implications and the risk of incurring losses upon eventual sale. If the stock’s value appreciates compared to the value at vesting, any gain realized will be subject to taxation. Your holding period determines the tax treatment of your gains. If you sell the shares within a year of purchase, you’ll face short-term capital gains tax, usually at higher ordinary income tax rates. On the other hand, if you hold the shares for over a year, you’ll qualify for the lower long-term capital gains tax rates.
Conversely, if the stock’s value declines and you decide to sell, the loss incurred will be treated as a short-term capital loss. You can offset this loss against any short-term gains or offset up to $3,000 (as of 2023) of the loss against your ordinary income. Any remaining loss can be carried forward into future years for potential offset against future gains or income.
The more significant risk for many employees is concentration risk. The concentration of risk poses a significant challenge for corporate executives, as they often find themselves with a substantial portion of their wealth tied to their company’s stock. This situation arises when executives, buoyed by the company’s success, may inadvertently put their compensation packages on cruise control without considering the potential risks. Over time, their company stock holdings can grow disproportionately, leading to an over-concentration of wealth in a single asset – their employer. While this strategy may seem advantageous during a period of growth for the company, it exposes employees to the inherent volatility and uncertainties associated with the company or industry. Downturns or adverse events impacting the company’s stock price can flow through to employment as well, with layoffs or downsizing happening simultaneously as a significant decline in the employee’s portfolio due to the concentration in company stock, significantly impacting financial well-being.
Recognizing and addressing the risk of concentration is vital, and you should carefully evaluate your portfolios, diversify holdings when possible, and seek professional guidance to mitigate the potential pitfalls of holding a large percentage of company stock.
Tax Planning
So when should you sell immediately, and when should you hold? The answer partly depends on your outlook for the company’s future; the rest of the decision should rely on solid, proactive tax planning using your RSU vesting schedule. By coordinating the timing of other taxable events with your RSU vesting, you can manage your tax brackets more effectively and lower your tax liability.
For effective tax planning, you should create a forecast that spans multiple years or even decades, extending beyond the year your RSUs vest. Include all forms of compensation you may receive, such as deferred compensation or options. This proactive approach helps you prepare for future tax obligations, including the onset of Required Minimum Distributions (RMDs) from retirement accounts. The age for RMDs now starts at 75 for most people, although the SECURE 2.0 Act adjusts this based on birth year. RMDs can significantly affect your taxable income and tax bracket.
Using a multi-year forecast, determine whether you’ll fall into a higher or lower tax bracket in the future. If you expect a lower bracket, aim to defer as much income as possible to those later years. Conversely, if you anticipate a higher bracket, consider pulling income forward to “fill up” your current bracket. Depending on the company’s size and the flexibility of its restricted plan, you might be able to negotiate the vesting schedule to align with your tax strategy. Employers are generally more open to this if they have the capability and if you’re willing to extend the vesting period, effectively taking on more risk.
By creating a comprehensive tax plan including RSU impacts, you can craft a comprehensive tax strategy that maximizes your realized after-tax compensation – the only number that matters!
Advantages & Disadvantages
If you’re fortunate enough to be negotiating your compensation package and are weighing Restricted Stock against other options, consider the following advantages and disadvantages:
Advantages
Potential for Financial Gains: RSUs offer you the opportunity to benefit from your company’s success. As the stock price goes up, so does the value of your RSUs, potentially leading to substantial financial gains.
Lower Risk: RSUs are generally less risky than other compensation forms like stock options. Even if the stock price falls, your RSUs hold some value unless the company’s stock becomes entirely worthless. This lower risk can give you a sense of financial security and stability.
Simplicity: RSUs are simple to understand and manage. Your company takes care of the administrative details, such as allocation, vesting, and taxation, allowing you to concentrate on your job without worrying about managing your compensation plan.
Disadvantages
Limited Tax Planning: Unlike stock options and other equity compensation forms, RSUs offer fewer ways to strategize around taxes. You’re generally taxed upon vesting, and taxes are withheld from your employer, leaving you with limited options to reduce tax liabilities tied to RSUs.
Risk Concentration: Holding a large amount of your company’s stock, including RSUs, exposes you to concentration risk. With much of your wealth in a single stock, you become vulnerable to the company’s performance and stock price volatility. Diversification is critical to managing this risk.
Risk of Losses: If your RSU shares decline in value from the grant date, you might feel like your compensation has decreased. Keeping the shares after vesting may result in selling at a loss. Carefully consider the risk-reward trade-off before deciding to hold or sell.
Limited Flexibility: Once your RSUs vest, your choices for when and how to sell the shares narrow. This lack of flexibility can limit your ability to seize market opportunities or adjust to financial changes.
You must carefully assess the pros and cons of RSUs, considering your financial goals, risk tolerance, and diversification strategy. Consulting with financial advisors or wealth managers specializing in equity compensation can offer valuable insights. Their expertise can help you navigate RSU complexities and make decisions that align with your long-term financial goals.
Summary
Restricted Stock Units (RSUs) are an integral part of executive compensation, providing a means to share in the success of the company you serve, and are a low-risk compensation option when compared to more risky components such as stock options. Understanding the tax implications associated with RSUs and creating a tax plan is crucial to maximizing your financial gains and avoiding unexpected tax liabilities.
Still, it’s important to recognize that tax considerations alone should not drive a decision to continue to hold company stock. While minimizing tax liabilities is crucial, concentrating too much wealth in a single stock can pose an equal, if not greater, threat to your financial independence. The potential risks of holding a concentrated position in company stock, such as stock price volatility or adverse events impacting the company’s performance, can outweigh the tax advantages.
Diversification is crucial for robust financial planning, as it helps spread risk and safeguard against unexpected events. By thoughtfully weighing tax optimization against risk reduction, you can make informed choices prioritizing long-term financial health and aiming for a balanced, diversified portfolio. Consulting with financial advisors or wealth managers can offer valuable insights, helping you find the right balance between tax efficiency and risk management.
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