Restricted Stock Units (RSUs) are common as equity compensation for employees in the corporate world. A company may use them to make a job offer more attractive or to reward one’s performance. As seen the past few years with a rising U.S. equity stock market, RSU values have continued to increase but with a seemingly murky understanding of the issues surrounding how they work. And a potential misunderstanding of the overall tax implications over time.
While a nice perk from your employer, RSUs come with many options and potential impacts to consider. For example, since they count as income when you obtain ownership at vesting, RSUs can significantly increase your taxes.
If you want to avoid significant tax implications and maximize the value of RSUs, it may take some strategic planning. Depending on your personal situation, the timing of when shares vest could influence whether it’s a good idea to hold onto them or sell right away.
Understanding the issues related to RSU grants, investments, and taxes can help you determine what steps to consider. This article addresses some of those issues and how you might get the most value from RSUs.
How RSUs work
RSUs grant you actual shares of company stock, typically for no cost. When the RSUs vest, they are worth the stock’s fair market value at time you acquire them. As the stock price increases or decreases, so does the value of the RSUs.
For example, if you receive 1,000 RSUs and the company’s stock is worth $50 per share when they vest, the RSUs would be worth $50,000. If the stock price was to increase to $100 per share four years after vesting, the total RSU value could become $400,000.
The timing of vesting is important because that’s often when taxes are triggered. When or if you decide to sell the shares after they vest will incur additional taxation.
Receiving RSU grants
When you’re granted RSUs, you should receive information on the conditions of vesting, which can vary by each company’s plan.
How RSU vesting works
Any event that triggers vesting should be closely monitored to avoid a surprise tax liability. These are a couple of ways the plan may treat RSU vesting:
- The shares fully vest after a number of years or follow a graduated vesting schedule over multiple years. Many large companies, such as Nvidia, Microsoft and Amazon, utilize this type of vesting schedule.
- Vesting is tied to a liquidity event or performance goals, instead of (or in addition to) a vesting period expiring.
Deferring distribution
Your plan may allow you to defer distribution of the shares after they vest. You can then hold them until a later date such as when you retire. If you do defer, consider when it will be beneficial to sell and incur taxes based on your overall retirement or financial plan. Clarify which events could potentially accelerate any deferred payments.
Taxation at vesting
According to conditions for the RSUs, there will be a taxable event for which the IRS will want its share of that income. In order to pay these taxes, companies will often withhold a certain percentage of income to cover state and federal income taxes. This is typically referred to as a cash settlement, where the company can hold some of the shares back or allow you to sell some of these shares to cover taxes.
Taxing dividend equivalents
If your company pays dividend equivalents while you’re holding the RSUs, consider how this may affect your cash flow and tax liability. You could receive dividend equivalents in cash or by way of additional RSUs.
The company might withhold income taxes on the dividend equivalents when you receive payment. Alternatively, the company may defer tax liability to when the RSUs vest. The amount could be substantial.
Terminating employment
Review how termination of your employment (voluntary or involuntary), disability, or death might affect your RSUs. Generally, termination causes forfeit of the RSUs that haven’t vested, unless vesting accelerates under your plan.
RSU investments
When considering investment options with RSUs, the right decisions are likely going to depend on your personal financial situation. But it’s also important to pay attention to laws and limitations related to holding or selling the stocks.
Concentrated stocks
Shares of your company’s stock, including unvested RSUs, may make up a significant percentage of your investment portfolio. If so, consider tax-efficient diversification strategies. Risks can come with maintaining a concentration —generally 10%-20% or more — in your company’s stock. An often overlooked issue with concentrated stock is when the company’s stock returns less than a diversified portfolio of U.S. stocks over time.
Blackout periods and trading windows
Check to see if your company has a blackout period, trading window, or other limitations on selling shares.
A blackout period prohibits employees from buying or selling company stock within a certain amount of time. The period is typically in place to prevent insider trading, like just before releasing quarterly earnings. You may not be able to sell the shares immediately even though they are now taxable as income. This can create a cash flow issue if you were planning to sell shares to cover the tax liability.
A trading window is the opposite of a blackout period and typically communicated to employees for planning purposes. The window designates a period when employees are able to trade company stock. These windows usually open shortly after public disclosure of earnings and remain open for a few weeks.
Downside protection
Consider different strategies for limiting potential losses while holding your company’s shares during a market downturn.
For example, buying put options may help limit your downside, but only if your company permits the use of these types of risk mitigation strategies. Put options give you the right to sell your shares at a predetermined price, potentially offering some insurance if the company stock declines. You might also use investments with negative correlation or low-cost collars. These help limit the impact of the stock moving down by also limiting the benefit from the stock moving up.
Selling RSUs at a loss
If you’re thinking about selling your company shares at a loss, the timing of your sale and potential RSU grants or vesting may trigger wash-sale rules. A wash sale occurs when you sell a security at a loss and then buy basically the same security within 30 days before or after the sale.
RSU taxes
At the time you receive a grant of RSUs, they do not incur taxes. The IRS doesn’t recognize the income as taxable until the shares vest.
RSUs count as income
Upon the transfer of RSUs (or cash) to you, the fair market value (FMV) of shares is taxable compensation. This occurrence will result in federal and any state and local income taxes. A taxable event typically occurs at vesting but there can be a deferral in certain circumstances, such as if your plan qualifies for Internal Revenue Code (IRC) Section 409A. This income is also subject to FICA taxes in the year of vesting, regardless of any elective deferral.
Reducing income tax liability with vesting RSUs
To help reduce your taxable income, you could maximize deductible savings in your tax-advantaged accounts. These account types include 401(k), 403(b), 457, traditional IRA, health savings account (HSA). Another strategy is “bunching” which means timing your deductible expenses to help maximize your ability to take itemized deductions. For instance, taking advantage of a donor-advised fund or charitable gifting.
Planning for tax withholdings
Upon vesting, your employer is required to withhold taxes according to the withholding rates for supplemental wages. Depending on your tax situation, this could be insufficient, and you would need to make estimated payments. Alternatively, your employer may automatically retain sufficient shares to cover withholdings and issue the remaining shares to you. If you have a choice under your plan, you may also be able to sell shares to cover withholdings or pay with outside funds.
IRC Section 83(i) election option
Does your company offer the IRC Section 83(i) election? This allows for deferring the recognition of income for up to five years after your RSUs vest. If so, and if you are a qualified employee, consider whether making this election provides an attractive tax benefit. Note that there are potential risks of a decline in share value during the deferral period.
Selling RSUs after they vest
When you sell shares of stock, you may have capital gains or losses if your sale price is higher or lower than your cost basis. Your cost basis should equal the amount you paid for the stock (if any) plus the amount included as taxable income.
If you hold the shares for more than one year, capital gains or losses will be subject to long-term tax rates. The long-term rates are typically lower than ordinary income tax rates. Holding the shares for less than a year will be subject to short-term capital gains which are taxed using your ordinary income rates.
Taking control
Your considerations for how to handle RSUs could be different from everyone else, depending on your situation. Knowing your options and strategies are key to helping manage your cash flow, taxes, investment portfolio, and more. It’s worth a reminder that one oversight along the way could be incredibly costly.
This article provides guidance for some, but not all, of the issues that might come with receiving RSUs. Therefore, we would encourage you to consider consulting with financial professionals to help you build a strong financial strategy that can potentially help mitigate stock concentration, and/or optimize taxes. If you’re a Mercer Advisors client, reach out to your wealth advisor if you have RSUs.
At Mercer Advisors, we specialize in helping professionals navigate the complexities of RSUs, maximize value, and minimize tax liabilities. We also connect the dots of your financial life by unifying financial planning, investment management, tax, estate, insurance, and more.
If you’re not a Mercer Advisors client and want to know more about how we can help you with RSUs and other types of compensation, as well as building your wealth, let’s talk.
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