Restricted Stock Units (RSUs) are a form of compensation paid to employees based on job performance and loyalty. They are potential stock shares conditionally promised by the employer. The promise is that at some future time the company will deliver one share of stock to you for every RSU awarded. The vesting of RSUs and remittance of shares usually occurs in phases over two to five years.
What You Need to Know About RSU Taxation
When they vest RSUs are included as taxable income. Because they are considered supplemental income, the withholding rate can vary between 22% and 37%. Usually, your employer will liquidate a percentage of the shares to cover the federal tax withholding requirement. RSU income may also be subject to state and local income taxes.
RSU Vesting, Withholding, Selling Explained
While RSUs can boost your portfolio and net worth, there are strings attached. Commonly, you have to stay with the company for at least a few years or meet performance milestones to “un-restrict” all of the shares. You need to be mindful of tax triggers in different scenarios. RSUs are equity compensation through which an employer promises to give you shares of company stock, once certain vesting requirements are met. They are granted through a document that outlines the details of the vesting requirements. You have no ownership of the shares until you are vested. They hold no immediate financial value and cannot be sold or transferred, and they don’t require any upfront purchase. Once you meet the vesting requirements you receive the shares.
The vesting schedule outlined in your grant document will likely follow one of the following methods:
- Cliff vesting: All shares vest at once, after a fixed vesting period (e.g., four years with the company).
- Graded vesting: Shares vest in increments (e.g., 25% annually for four years).
- Hybrid vesting: This is a blend of cliff and graded vesting. For example, 25% of your RSUs could vest after one year, while the remaining shares vest in equal, monthly lots over the subsequent three years.
Tax Implications and Strategies after RSUs Vest
Once RSUs vest, they are treated like normal shares of stock. The tax basis in the shares will be their market value when they vest – the same value that would be taxed as income. When you sell the shares, the resulting capital gain or loss will be included in your tax filing. To qualify for preferential long-term capital gains treatment (max of 20%), the shares must be held for one year following the vesting date. Otherwise, the capital gain will be short-term and taxed at your ordinary income rate in the year sold.
The IRS mandates a 22% withholding rate for supplemental income up to $1 million. There are different ways to address the liability:
- Sell-to-Cover: This is the default method for handling taxes on vested RSUs. In this approach, the employer automatically sells a portion of the vested shares, usually assuming a 22% withholding rate. This typically covers federal, state, and payroll taxes.
- Withhold-to-Cover: Rather than selling shares, the employer might choose to retain shares and pay the exact tax liability with cash on hand. This can help avoid overselling or underselling shares that can happen with Sell-to-Cover, as many brokerages don’t allow fractional sales.
- Same-Day Sale: Upon vesting, you could elect to sell all vested shares immediately. This method not only covers the tax liability but also converts all your shares to cash. This could be useful if you need the cash or you’re over-concentrated in the employer’s stock.
- Cash Payment: If you believe in the company’s long-term strategies and prefer to hold your vested shares, the employer may allow you to pay the withholding tax with cash. This requires you to have sufficient liquidity on hand to cover the tax bill, which can be significant depending on the number of shares and their market value.
Each of these strategies has benefits and trade-offs; the best choice depends on your financial situation, market conditions, investment strategy, and overall portfolio allocation.
It’s worth noting that the default withholding won’t necessarily cover your tax obligation. You could owe more beyond what’s initially withheld. If this applies to you, consider setting aside funds or selling additional shares as they vest.
If you work for a private company that intends to go public, the RSUs could require a “double trigger” to fully vest. You may have to meet a time-based requirement and wait for a liquidity event (e.g., an IPO) to receive your shares. This could mean a longer holding period. This double trigger helps non-public company employees, in that it delays a taxation event to a point where shares could be sold to pay for the tax burden of vesting.
How RSUs are Taxed at Sale
Once your RSUs have vested and you decide to sell them, any profit you make from the sale is subject to capital gains tax. This tax rate depends on how long you've held the shares after they've vested.
Short-term capital gains: If you sell your RSUs within a year of vesting, any profit is taxed at the same rate as your ordinary income.
Long-term capital gains: If you hold your shares for more than one year after they vest and then sell, your profit is taxed at the long-term capital gains rate, which is lower than the ordinary income tax rate for most taxpayers.
Volatility is an important factor. Single stocks are often prone to price fluctuations, so waiting could erase the tax benefits if the stock price declines. For most people, selling RSUs as they vest and diversifying the proceeds into a broader portfolio offers the most secure and tax-efficient strategy because capital gains would be negligible if sold immediately. However, if you believe in the company’s growth and want “skin in the game,” it’s prudent to limit your exposure to no more than 10% of your portfolio.
Incorporating RSUs into Your Financial Plan
RSUs can make up a substantial portion of total compensation. There are several considerations when including them in your overall financial plan. It is crucial to work with a financial planning professional to ensure your RSUs and other long-term incentives are properly integrated into your financial plan.
If you're receiving restricted stock or other forms of equity compensation, you could benefit from wealth management. Tax professionals and Financial Advisors well-versed in equity can help you look ahead to incorporate, diversify, and maximize your earning potential. If you want to make informed decisions about your equity holdings, professional guidance is key.
Your Strategic Stewardship Advisor will gladly help you build RSUs into your overall financial plan. Contact us to set a time to discuss making the most of your equity compensation.