Restricted stock units, or RSUs, are a form of equity compensation often awarded to executives or employees in the technology industry. They’re used as an additional form of compensation in addition to a salary. They can be viewed as bonus compensation but as company stock. RSUs can be extremely valuable and offer several planning opportunities to assist in reaching your financial goals. However, if you’re not familiar with their mechanics, tax implications, or other opportunities they provide, you’re likely left asking what to do with my RSUs? This article will provide everything you need about restricted stock units to maximize their benefit for your financial goals.
What Are Restricted Stock Units (RSUs)?
Restricted stock units (RSUs) are a type of stock-based compensation companies provide to employees as a reward for performance, length of service, or other reasons. RSUs are restricted because they have conditions that must be met before the shares “vest” and can be sold or otherwise used for the employee’s benefit.
RSUs are fairly popular among technology companies, whether private or public. They provide a way for high-flying, growth-oriented companies to compensate employees with equity and salary. These companies are reinvesting heavily into their business and offering employees the opportunity to benefit from that growth. Companies will provide a grant document outlining the number of shares, vesting schedule, and other details surrounding the RSUs, which can be used when developing your financial plan.
Benefits of RSUs
From a financial planning standpoint, RSUs should be viewed as a bonus. All else being equal, when RSUs are released to employees, they are no different than a cash bonus. The only difference is they’re received in the form of company stock. If you were to sell the stock immediately, it’s the exact equivalent of a cash bonus. Vice versa, if you received a cash bonus and chose to use the entirety of the bonus to buy your company stock, it’s the equivalent of RSUs being released. Of course, there are differences in tax implications, how tax withholding works, and the mechanics of selling the stock to “realize” the bonus.
As with any bonus, RSUs can supercharge savings, investments, or progress toward particular financial goals. Since they’re received in lump sums and potentially large windfalls, evaluating how to use the proceeds and reflecting upon your goals before making a decision is essential. RSUs can help fund your child’s college education, remodel your home, purchase a home, or long-term retirement savings. A pitfall to avoid is having no plan, failing to evaluate your circumstances, articulating your goals, and underutilizing their benefit.
Millennial Wealth Tip:
A holistic financial planner will be able to assist in providing actionable steps around your RSUs and ensuring they align with your goals. They’ll also help ensure you understand the tax implications and aren’t caught off guard with a large tax bill come tax filing time.
RSU Grants Explained
RSUs are typically granted to employees upon hire. The employer will provide a total number of shares, vesting schedule, and other terms related to the RSUs as part of total compensation in their offer letter, employment agreement, and/or grant document. It’s essential to review the terms of the RSU grant before accepting. Often, the employer will target a specific amount of compensation in coordination with the employee’s base salary. For example, a base salary of $200,000 and a grant document outlining a total RSU compensation of $250,000 over four years.
The $250,000 target for equity compensation is then converted to a specific number of shares based on the company’s current fair market value. The total number of shares to vest over the four years is outlined in the grant document. The value will fluctuate over time as the company’s stock increases or decreases.
The grant document is the first step in reviewing RSUs and any specifics related to your company’s equity compensation plan. It’s important to understand how they’ll impact your total compensation. There may be room for negotiation if you work for a company whose stock price is highly volatile or vice versa.
Vesting Schedule
Time-Based Vesting
The most common type of RSUs use a time-based vesting schedule. Companies will provide a vesting schedule that releases the RSUs to the employee over a predetermined period. The vesting schedule will be outlined on the grant document the employee will sign while accepting the RSUs.
For example, an employee receives 10,000 shares of RSUs in XYZ company, vesting over four years. After one year, 25% of the shares vest, or 2,500 shares. Every quarter after that, another 6.25% of the total granted shares will vest, with the final allotment of shares vesting on the fourth anniversary of the original grant date.
Companies can “frontload” the vesting schedule using a cliff vesting schedule, such as the one described above. Or vice versa, where more shares vest near the end of the vesting period. From the company’s perspective, this provides an additional incentive to help retain employees since part of their compensation depends on the time-based vesting schedule.
Performance Based Vesting
Another type of vesting is based on performance. If the company meets specific revenue, profitability, or other metrics outlined in the grant document, RSUs may be triggered to vest to the employee at that time. This type of vesting schedule may also contain a time-based component but generally is more complicated to plan for since it’s unknown if and when the performance metrics may be met.
Double Trigger RSUs
Finally, for many pre-IPO companies who’ve yet to experience a significant liquidity event (such as an IPO), may offer “double-trigger” RSUs. They are structured with a time-based component that vests over a particular period AND requires a liquidity event.
Whence the term “double-trigger,” as both vesting conditions must be met before being released to the employee. The second trigger is often met through an IPO but could also be met if the company is sold or a large private equity investor injects capital into the company. These RSUs are also more challenging to plan since it’s more difficult to pinpoint when the liquidity event will occur and when the RSUs will ultimately be released.
Millennial Wealth Tip:
Technology industry employees may frequently feel they can’t leave a company due to the value of the RSUs that have yet to vest. If they’re unhappy and ready to leave for a new opportunity within tech, we’ve had success in evaluating the estimated value of the unvested RSUs and using that in negotiations for new equity compensation or higher base salary with other potential employers. It’s essential not to disregard the RSUs as part of total compensation in negotiations, as other employers “should” be willing to meet your total compensation, including the value of the unvested RSUs you’d be leaving behind.
How Are Restricted Stock Units Taxed?
RSUs are taxed as ordinary income through payroll. After an RSU vest, if you review your paystub, you’ll notice a line item is created next to your salary and other income sources. The value of your RSUs on the vesting date will be listed here as part of your income.
For example, if the vest incurred $100,000 in income, it would be taxed at ordinary income tax rates and appear on your pay stub. Typically, employers will set a standard 22% federal tax withholding rate on RSUs, with some allowing you to increase that percentage up to 37%. Other taxes may include social security, medicare, and state income taxes. If you’ve already maxed out social security taxes for the year, there won’t be withholding for social security.
Finally, once the vest occurs, the stock is sold to cover the taxes listed above unless you’ve opted not to withhold for taxes. It’s typically advisable to withhold taxes to ensure you’re not caught off guard by a significant tax bill or assessed penalties for under-withholding throughout the year.
Strategies for Managing Tax Liablities
For high-income earners with a significant amount of income from RSUs, it’s beneficial to work with an advisor who will provide tax withholding projections for the year or estimated tax payments that will get you above the “safe harbor” withholding limits to ensure no penalties are assessed.
Since RSUs aren’t taxable until they vest, it can be hard to predict precisely how much income they will produce over an entire year, as their value changes daily depending on the stock price. We typically run at least two tax withholding projections annually to ensure we’re within the safe harbor limits and avoid any tax penalties for clients. Or, if you’re working with a tax preparer, they can provide quarterly estimated tax payments to ensure you avoid penalties as well.
Finally, it may make sense if your company allows you to increase the tax withholding on RSUs from the baseline 22% up to 37%. Especially if the plan is to diversify away from company stock as it vests, you could pay the expected tax liability immediately following a vest and recognition of income.
RSU Taxation Case Study Example
Let’s assume that an employee earning $150,000 annually at Amazon also received another $100,000 in RSUs this year for a total income of $250,000. The RSUs were taxed using a 22% federal withholding rate, so $22,000 was withheld when the RSUs were vested for federal tax purposes.
Let’s assume $23,000 was withheld throughout the year on the base salary for federal taxes. Total tax withholding for the year amounts to $45,000. However, the total tax liability for the year based on gross income of $250,000 is $53,000, so this person would owe an additional $8,000 when filing their taxes. This can be a major surprise in the absence of any tax planning. You can imagine how this deficit can grow the larger the stock vest.
Since the federal income tax brackets are marginal, not every dollar of income is taxed at the same rate. Every dollar is taxed at a higher rate as your income grows. When you get into the +24% income tax brackets, the 22% withholding on RSUs will often not be enough to cover your total tax liability. See the graphic below, which explains how this scenario would be taxed (our example client uses the standard deduction, which is why the ordinary income figure is less than $250,000).
It’s important to note that all income is treated the same regarding federal income tax planning. Just because you received some income in the form of salary and the rest in RSUs does not change your total tax liability at the end of the year. The only difference is how much tax is withheld on salary and RSU income.
Deciding When to Sell RSUs
After your RSUs vest, how do you determine whether to keep or sell them? In a vacuum, you can evaluate the company’s fundamentals and determine whether it’s a “good” investment. A “good” investment can be subjective, depending on who’s analyzing the stock and what particular lens you view it through. Not to mention, there are inherent biases at play when determining whether to sell company stock.
You work there and are familiar with the culture, day-to-day work environment, particular growth strategies, etc. However, this can make people overconfident when evaluating a stock and its future trajectory. Remember, an RSU is a bonus received in stock rather than cash. If you were given cash outright rather than the company stock, would you use all that cash to purchase your company stock? If the answer is no, you likely aren’t making an unbiased decision on whether to keep or sell your RSUs.
Instead, the best way to evaluate whether to keep or sell your RSUs is to view them through the context of your entire investment portfolio or, better yet, your holistic financial plan. Develop a “rules-based approach” to managing your RSUs that eliminates emotional decision-making.
Assuming the RSUs are in a company with solid fundamentals and long-term growth trajectory, you could determine that you will only allocate around 10-15% of your investment portfolio at maximum to the stock. When you exceed that maximum, you’ll sell vested RSUs to get your asset allocation back in line. That way, you’re not creating a scenario where the majority of your net worth is tied up in company stock, and your long-term financial success is largely dependent not only on your paycheck but also on the performance of the company stock.
Finally, if you sell RSUs immediately after vesting, there are no additional tax implications. When RSUs vest, the shares establish a cost basis, which is the number of shares multiplied by the price on the day of the vest. Any future gains or losses from that share price dictate whether you’ll pay taxes when you sell the stock.
If you sell immediately, there is no difference between your basis and the current stock price, meaning no capital gains taxes are due. Again, why can you compare this to a cash bonus? By keeping the stock, you decide to invest that bonus in your company stock.
Other Factors to Consider Before Selling
As mentioned above, if you’ve opted to keep your RSUs in the past and you’ve been lucky enough to benefit from the growth of that stock but are ready to diversify, you’ll need to consider capital gains taxes before doing so. You’ll be subject to long-term capital gains if you’ve held the stock for more than one year from the vesting date. If you’ve held it for less than one year from the vesting date, short-term capital gains. Long-term capital gains are taxed at a preferential rate of either 0%,15%, or 20%. Short-term capital gains are taxed at ordinary income tax rates.
In our prior example, if the individual realized $50,000 of long-term capital gains in the year, it would increase taxable income to $285,000, as capital gains need to be added to total income to determine which rate they’ll be subject to. See the graphic below that outlines how the $50,000 in long-term capital gains will be taxed in this scenario.
When determining whether to sell RSUs, it’s also essential to determine the capital gains taxes attributable to the sale if the stock is not sold shortly after vesting. Failure to do so can also result in a tax headache during tax filing time.
Importance of Diversification
I diversified my RSUs, and my company stock has significantly outperformed my diversified portfolio! This could certainly be the case. However, you cannot view investments or financial decisions singularly. First and foremost, hindsight is always 20/20. There will ALWAYS be investments that “outperformed” over a specific period, but it’s extremely difficult to time the market and move in and out of said investments. Your RSUs should be treated no differently.
Instead, view them through the lens of a holistic diversified portfolio. Holding a concentrated stock position built up over time through RSUs vesting can pose a significant risk to your plan. It’s somewhat counterintuitive, but you can increase the likelihood of reaching your long-term financial independence goals through diversification and creating a more predictable portfolio in terms of volatility and risk-adjusted returns.
The more concentrated your investments, the more likely you’ll have increased volatility and less predictable long-term returns. Why risk your long-term financial success when it’s not necessarily needed? Of course, everyone’s situation is different and should be evaluated before making a broad assumption. Still, generally speaking, diversification benefits all investors and is often referred to as the “only free lunch” in the investment world.
Incorporating RSUs into the Overall Financial Plan
RSUs, by their nature, can provide large lump sums of cash at vesting and, therefore, provide significant progress toward financial goals. For example, let’s assume a family wants to remodel their bathrooms.
Their base salary cash flow won’t allow them to build enough cash quick enough for their timeline, however, they have quarterly vesting of RSUs that provide large lump sums of cash after sale. They can allocate the next vest towards the bathroom remodel rather than dipping into their emergency funds, taking a loan, or selling investments from their diversified portfolio.
Another strategy we oftentimes help clients employ is maxing out their “after-tax” 401(k)’s for someone who wants to supercharge their retirement savings.
Similar to the prior example, the client may not have enough cash flow through their salary to contribute to their after-tax 401(k), which has a more significant contribution limit than pre-tax and Roth 401(k). The after-tax 401(k) contributions will reduce their take-home pay. Therefore, when RSUs vest, we offset the annual contributions into the after-tax 401(k) by setting aside enough cash in their high-yield savings account.
This ensures they don’t deplete their cash due to reduced take-home pay and shovels more money into their after-tax 401(k), ideally having a Roth conversion mechanic to complete the “mega backdoor Roth.” Ultimately providing more tax-advantaged compounding of investments over long periods.
These are a few examples of how RSUs can help bolster financial goals and provide considerable flexibility in planning.
The Bottom Line
RSUs can provide a significant benefit to employees. However, they require careful tax planning to ensure penalties and interest are not assessed due to under-withholding on taxes throughout the year and determining whether to diversify into other investments or use them towards other financial goals.
While their mechanics are generally straightforward, a financial planner professional can ensure you’re maximizing their benefit while helping you succinctly outline what is most important to you through the financial planning process.
Schedule a free consultation today if you need help determining what to do with your RSUs.
