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Restricted Stock Units

Restricted Stock Units

November 4, 2020

Do you work for a company that offers Restricted Stock Units? There are many types of equity compensation that your employer may include in your compensation package, and each kind has its own set of rules that apply to how the equity is managed, granted, and taxed. It’s important to understand the nuances of each type of equity to maximize the benefits.

Restricted stock units and restricted stock awards are common types of equity companies offer to employees. They offer you a future promise of value based on the stock price of your company when restricted stock vests.

Vesting is dependent on a specific vesting schedule. The vesting period could be as little as one month or more commonly four years. You must stay employed with your company during the vesting period in order to access the stock once it has vested.

While your restricted stock units are vesting it’s a good time to develop a clear understanding of how your restricted stock works and how it can benefit you. Now is the time to develop a strategy for how to best manage your restricted stocks in your financial plan.

In this article, we’re going to discuss what restricted stocks are, how they affect your taxes, and the best strategies to get the maximum benefits to meet your unique financial short-term and long-term goals.

What are Restricted Stock Units?

Restricted stock units (RSU) are stock-based compensation awarded to employees. As noted above, the RSU will vest over a predetermined amount of time, at which point you can access the stock to do as you wish.

Vesting is the process of earning an asset. Companies use vesting to incentivize employees to stay with the company longer and eventually earn a reward for their loyalty. RSUs may be performance-based or time-based. A four-year time-based is more common, where you’re rewarded for staying with the company for the determined time of the RSUs.

The nice thing about Restricted Stock Units is you do not need to purchase them. They are awarded to you at no cost. You only need to wait for them to vest before they’re accessible to cash out, trade, or keep.

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What is Time-based Vesting?

Many time-based vesting schedules have a “vesting cliff.” A cliff is when the first portion of your option vests. After the cliff, you typically will gradually vest the remaining option each month or quarterly.

A lot of companies offer a one-year cliff. This means if you’ll need to stay with your company for at least one year to exercise any options.

Under a standard four-year time-based vesting schedule with a one-year cliff, one quarter of your shares may vest after the first year. After the cliff, 1/36 of the remaining grante shares vest each month until the four-year vesting period is over. After four years, you are considered fully vested.

Keep in Mind: Each option grant has its own vesting schedule - vesting isn’t based on your overall tenure at your company. If you get an option in 2020 with a four-year vesting schedule and another in 2022 with a four-year vesting schedule, you wouldn’t vest all of the options in both until 2026.

Restricted Stock Vesting Example

XYZ, Inc. hired you on November 1st, 2020. As part of your compensation package, XYZ. Inc. gave you RSUs with the following details:

  • Grant date: 11/1/2020
  • Options granted: 192
  • Vesting schedule: Monthly for four years with a one-year cliff

One year after your hire date, on November 1st, 2021, you reached your cliff and ¼ of your shares (48 shares) vest. You can now exercise those 48 shares how you wish.

DateOptions VestedCumulative
Nov 1, 20204848  (192/4 = 48)
Dec 1, 2020452
Jan 1, 2021456
Feb 1, 2021460
Mar 1, 2021464
Apr 1, 2021468
May 1, 2021472
Jun 1, 2021476
July 1, 2021480

Over the next three years, four shares vest every month. By November 1st, 2024, you are completely vested and can exercise all 192 of the shares as you choose. If you leave your company before November 1st, 2024, you will surrender all unvested shares, which get returned to the company option pool.

Are Restricted Stock Units Risky?

RSUs don’t cost you anything out of pocket, but there is some amount of risk associated with them. The biggest risk is the possibility that the stock may go down. There’s a number of reasons a company’s stock can go down:

  • A general market decline
  • Loss of competitive advantage
  • Product recalls
  • Products replaced by superior innovations

The potential loss risk is minimal when you’re first starting out with a new company but over multiple years it’s easy to build up your employer stock. The more you build up, the more non-diversified risk you hold. The best way to reduce the risk of employer stock is through diversification. There are a number of strategies we’ll cover as you continue to read.

Restricted Stock Units

How Do RSUS Differ from Stock Options?

RSUs are similar to stock options, but they have some key differences worth understanding. In most cases, restricted stock units:

  • Don’t expire. They convert to shares after a vesting period.
  • Have the same fair market value during the vesting period
  • Complete a vesting schedule typically after 4-5 years
  • Get taxed as regular income when they’re vested

Stock Options:

  • Expire 10 years after received by an employee
  • Tie into the stock price - if a stock price drops below the grant price, the option’s value decreases.
  • When a stock price rises, the stock option’s value increases.
  • Get taxed at the time the options are exercised.

Are Restricted Stock Units Taxed Twice?

Like all investments, understanding how to best navigate taxes is key to maximizing their benefits. Because of the nature of RSUs, many people ask if they’re taxed twice. The short answer is yes, but let’s take a closer look at how that plays out.

There are two types of tax to consider with any kind of equity compensation: ordinary income tax and capital gains tax. The main thing to remember is that the capital gains tax rate is generally lower than the ordinary income tax rate.

Remember - any time your company pays you, whether in salary, benefits, or equity - you owe taxes on that income.

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So How Are Restricted Stock Units Taxed?

The key thing to keep in mind with RSUs and taxes is that you pay ordinary income tax when your shares vest. For example, let’s say your RSUs had a fair market value of $10 when they were granted. Because you did not actually receive any shares when the RSUs were granted, you are not responsible for paying taxes on that $10. Therefore, the taxable gain is $0 on the grant date.

Instead, you will pay ordinary income tax on the full fair market value when your RSUs vest. You’ll pay taxes on their value of the vesting date. So if they’re now worth $15 you’ll pay taxes on that amount, not the grant amount of $10.

What about the double taxing part?

Well, you’ll again pay taxes on your capital gains for your vested stocks once you own them.

Restricted Stock Units

Are Restricted Stock Units Reported on my W2?

In most cases, your company will handle the taxes on your behalf, by withholding taxes automatically. They usually do this by simply selling some of the vested RSUs. For federal income tax, your company will most likely withhold only the legally required 22%. If your tax bracket is above 22%, then you’ll likely owe more in taxes. You can sell more stock to cover the additional tax burden if you choose.

What are the Main RSU Tax Withholding Methods?

There are four tax withholding methods for restricted stock units.

  1. In a same-day sale, all of your shares will be sold on the day they’re vested. The money can be used to pay taxes.
  2. With cash transfers, money is deposited from your account to pay taxes.
  3. Using a sell-to-cover method, you’ll receive shares at the end of the vesting period. Your broker can sell the shares to cover tax expenses, and you can keep the remaining shares.
  4. With a net share settlement, your company can retain some of the vest RSUs. The shares will be equal to the withholding tax amount. The remaining units can be deposited into your brokerage account.

Should I Sell Restricted Stock Units When They Vest?

Your restricted stock units have vested - now what? Now it’s time to implement your RSU strategy. The RSU strategy you choose should make sense for your financial needs and overall plan for the future. If you choose to sell your RSUs there are a few questions to ask first:

  • Why are you selling? - Are you looking to diversify out of a concentrated stock position? Is there another specific asset you’re looking to reinvest in? This is the first and most basic question you’ll need clarity on before selling your RSUs.
  • What is your company’s outlook? - Your company’s predicted future success and stock price will play a big role in your strategy, and deciding on whether or not selling is a good long term strategy.
  • Does your employer require you to hold company stock? - Some employers require top-level executives to hold a certain amount of company stock in their portfolios.
Restricted Stock Units

RSU Selling Strategy Options

If you and your financial advisor conclude that selling makes the most sense you have several options when it comes to your restricted stock units due to the nearly unlimited amount of alternative investments you can shift your shares into after selling. For example, you may choose to sell half of your vested shares and diversify your portfolio by investing in a hard asset, like a rental income property.

5 Selling Strategies for Your Vested Restricted Stock Units

  1. Sell all Shares ASAP - This strategy can be ideal if you don’t have a favorable outlook on the share price of your company stock. If you believe the share price will fall, or it’s been falling, you might consider selling all of your shares. It’s important to know that if you sell between the six-month and one-year period, you will be subject to short-term capital gains tax, which would be the same as your ordinary income tax rate. If you wait until after the one-year mark, you can expect to pay long-term capital gains tax which is much lower in most cases.
  2. Sell a Portion and Keep a Portion - Another selling strategy is to sell off some of your shares and keep some. The strategy allows you to stay vested in the company but also diversify your equity holdings as well. This is a good strategy for executives looking for diversification but who also want or are required to stay vested in their company.
  3. Hold onto Your Shares - If you have an optimistic, long position of your company stock, you can choose to hold onto the stock for as long as you like. The goal would be for the stock price to rise over time, generating wealth as well as eliminating taxation from selling right away.
  4. Sell with a System - Many top-level executives, with the help of an experienced financial advisor, implement an index proxy strategy that systematically sells off shares. This strategy is especially effective when you have a large concentrated stock position that you want to diversify for risk management reasons.
  5. Exchange Fund Strategy - If your goal is to diversify your concentrated position but you’d rather not sell your shares and incur capital gains taxes, you can opt for an exchange fund strategy. This strategy allows you to pool your stock with other large positions to offer diversification to the group. In exchange for your large number of company shares, you are given shares of the overall fund that typically comprises 50 different stock positions.

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When is the Best Time to Sell Your Restricted Stock Units?

As noted above, it depends on your overall financial goals, but there are times that are more advantageous to sell. It often makes sense to sell the stock at the highest cost basis, which is oftentimes stock that has most recently vested.

Another example would be if your recently vested stock on October 15th goes down between October 15th and December 31st significantly, it can make sense to sell that vested stock to lock-in that loss, which can be used as a deduction against ordinary income or as an offset against capital gain you’ve realized elsewhere in your portfolio.

If you’ve owned stock in a company for a long time, that stock has a lot of gains. If you sell it, you’ll end up paying a lot of tax. So, the first shares that you get from your company, it’s often a good strategy to contribute to charity. This is great if you’re charitably inclined and would otherwise donate, and comes with an additional tax benefit.

Restricted Stock Unit Frequently Asked Questions

For a more in-depth explanation of these popular questions make sure to read the entire article above.

Q: What is a restricted stock unit?
A: Restricted stock units are grants valued in terms of your stock company. After a vesting period is satisfied (often four years), your company will distribute your shares and you will own them as you would any other stock.

Q: Am I taxed on my RSUs?
A: Yes. Once the vesting date has been met, taxable compensation is equal to the spread between the fair market value and the award price. Taxable compensation is usually the number of shares issued multiplied by the fair market value of the company stock.

Q: What happens to my RSUs if I leave my company before they vest?
A: Generally, if you leave your company before your RSUs vest, you lose the unvested RSUs. The RSUs that have already vested you will continue to own.

Q: Will my employer withhold taxes when my RSUs vest?
A: Companies are obligated to withhold taxes for compensation earned. Different payment methods may be available for you to meet your tax liability upon vesting RSUs. The most common method of payment is share withholding, where your company withholds enough shares to cover the tax liability.

Q: How is the tax withholding for my RSUs calculated?
A: Your employer will calculate tax withholding rates based on country, state, and local tax jurisdiction rules.

Q: Are there any restrictions when it comes to selling my vested RSU shares?
A: Insider trading rules apply to everyone. You may also be subject to your company’s trading policy and pre-clearance process and ownership guidelines.

Q: How do you value a restricted stock unit?
A: RSUs are assigned a fair market value at the time they become vested. If the company’s stock is valued at $50 per share at the time the RSU is vested, then the per-unit value of the RSUs is $50.

Q: Why do companies give restricted stock?
A: Restricted stocks reward and incentivize employees to align their interests with the future of the company.

Q: Is restricted stock considered income?
A: Restricted stock usually becomes taxable upon the completion of the vesting schedule. In restricted stock plans, the entire amount of the vested stock will be counted as ordinary income in the year vesting is completed.

Q: Can restricted stock be sold?
A: Restricted stock cannot be sold until it has vested. At that point, it will no longer be classified as restricted stock.

Q: Do you get dividends on restricted stock?
A: RSUs can’t pay dividends because no actual shares are used.

Q: Will Restricted stocks show up on my W-2? A: Yes, you will see it automatically reported on your W-2 the year the shares are delivered to you.

Q: What does vesting mean?
A: Vesting means ownership. If you’re 100% vested in your account balance it means you own 100% of it.

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