With stock markets fluctuating wildly, it’s especially important to understand the financial and tax implications of any company stocks your employer might offer. Restricted stock units, or RSUs, have become particularly popular in recent years. A 2017 survey by Ayco’s Compensation and Benefits group showed 72% of companies use RSUs, up from 37% just 10 years earlier.
So, how do RSUs work? They’re a type of equity-based compensation in which there is a period between when you’re granted shares of company stock and when you actually gain ownership (vesting) in those shares. RSU vesting is often contingent on a minimum tenure with the company, and the actual value depends on the market price of your company shares at the time they vest rather than when the RSUs are granted.
RSU tax treatment is relatively straightforward. You don’t owe any taxes until they vest — since the shares are not technically yours until then. In the year in which they vest, the value of the shares is considered ordinary income and is taxed as though you had received the same amount in cash. If you decide to hold onto the shares, any change in value is taxed as capital gains or losses when you sell the shares.
RSU Tax Treatment: Exploring Your Options
Let’s look at an example to illustrate better what RSUs are, how they work, and the choices you have when you gain ownership of these shares.
Emmitt is offered a compensation package with a $75,000 annual cash salary and a grant of 4,000 RSUs that vest quarterly over the next four years, or 1,000 per year. Shares trade at $25, so Emmitt’s total annual compensation can be estimated to be about $100,000 per year assuming a static stock price.
If Emmitt accepts this offer, he should first understand the tax implications of his RSUs that will vest this year. RSU income is subject to mandatory supplemental wage withholding for federal income tax, which is 22% on the first $1 million of supplemental wages and 37% once it exceeds $1 million. The actual tax on RSUs is often much higher, and Emmitt should review whether 22% is an appropriate withholding amount and adjust as necessary to avoid a big tax surprise.
Depending on how the company performs, the value of Emmitt’s actual compensation can vary. If the company shares drop in value, for example, the value of his total compensation will be lower than expected. Alternatively, if the company shares pop, Emmitt will find that his compensation is higher than expected and may need to adjust his tax withholding. In either case, it will be crucial for Emmitt to understand RSU tax implications.
Managing RSUs: Knowing When to Sell or Hold
Each quarter, when 250 of his RSUs vest, Emmitt has a choice to either keep his shares or sell them. If he sells, he can spend the proceeds or invest that money in something else. Ultimately, his choice will depend on his overall portfolio and long-term financial goals.
Here are a few guidelines that can help you decide whether to sell or hold based on RSU tax implications and your goals:
Reasons to Sell
- You plan to use the shares to fund a short-term goal. If RSUs are being accumulated to help support a short-term goal, such as a home purchase in the next 12 months, the prudent move is to sell and invest the proceeds in a safer investment. Holding a concentration of any single stock is a risky move for a short-term goal — if the share price falls just when you need the funds, you may miss your target.
- Your company shares make up a large amount of your net worth. While each situation is different, holding more than 10% of your portfolio in your employer’s stock, or any single stock, poses a significant risk to your financial well-being in the long run. The exact threshold is your choice, but it’s wise to set an upper limit for any single stock.
- Your goal is to have a completely diversified portfolio. Diversification is often called the only free lunch in investing because it is such a great benefit. If your strategy is to hold a completely diversified portfolio, sell your vested RSUs immediately and reinvest the proceeds into a variety of assets.
Reasons to Hold
- Your company shares are part of a broader portfolio strategy. This could be a reasonable plan as long as you limit your exposure to a single stock to 10% of your portfolio.
- You want skin in the game. While we do not recommend holding a concentrated position in your employer’s stock, it’s understandable to have some skin in the game with a company where you’re investing a lot of time and effort.
- You have to hold them. If you are an executive or a member of the board of directors, for instance, you may be required to hold a certain number of shares.
There are many acceptable reasons to retain your shares after they vest. There are, however, two common mistakes that employees often make. First, there is a confusion that there are tax advantages to holding vested shares. Regardless of whether you sell or hold them, RSUs are taxed as income when you vest — so there is no tax advantage to keeping them.
Second, it’s human nature (known as the endowment effect) to have a bias toward things we already own and to hold onto things we wouldn’t normally buy. Would you use all of your $25,000 cash bonus to buy your employer’s stock? If the answer is no, then don’t hang onto vested RSUs just because the compensation was given to you as stock rather than cash.
Whatever Your Strategy, Plan Ahead
In a time of financial uncertainty, many people are stressed for time and money. Parents are working from home while taking care of their children, and many workers are dealing with reduced pay and layoffs.
When time and money are scarce, even those of us who usually are good at managing our finances can make poor decisions. That’s why it’s more important than ever to review your goals and plan ahead for the best opportunity at a successful outcome. This is true whether it concerns your RSUs, your overall finances or any other life goals.
Daniel Lee, CFA, CFP®, is a financial planner dedicated to helping busy people make intelligent financial decisions by providing clear, straightforward advice free from conflict of interest. He is currently the head of the San Francisco office of Plancorp, a full-service wealth management company serving families in 44 states. Daniel is an award-winning instructor at UC Berkeley Extension and is a member of the CFA Society of San Francisco and the National Association of Personal Financial Advisors (NAPFA).
Contributor: Daniel Lee
Source: Equities News