Restricted Stock Units (RSUs) are a future promise of stock-based compensations offered to employees as part of their total benefits package. While RSUs are an excellent addition to your financial arsenal, they may have significant tax ramifications. Understanding how RSUs work and where they fit into your overall financial plan is important.
When RSUs are first granted, they are only a promise. Your employer is promising shares of company stock in the future. This is done through a vesting schedule. Once RSUs vest, they’re considered part of your taxable income. You take ownership of the shares and can decide how to use them.
Each grant of RSUs has its own vesting schedule. A vesting schedule is an incentivized, time-based carrot. It’s a way your employer encourages you to remain a long-term employee. Vesting schedules are primarily either graded or cliff.
Graded vesting: A predetermined percentage of your RSU award will vest after each year of service.
Example: You were granted 4,000 RSUs on 12/15/2022. Your graded vesting schedule spans five years, and 20% of the grant vests yearly. On each anniversary of your grant date for five years, 800 shares will vest.
Generally speaking, the majority of graded vesting lapses over three to five years. Sometimes, however, a graded vesting schedule has varying time intervals.
Example: You were granted 6000 RSUs on 12/15/2022. Three years after the grant date, 60%, or 3,600, of the shares vest. The remainder, 2,400 vests, 2 years later.
Cliff vesting: 100% of your RSUs vest after a specific time.
Example: You were granted 5,000 RSUs on 12/15/2022—five years after the grant date, 12/15/2027, 100% of the shares vest.
What happens if you quit your job or are let go? You lose your RSUs. The only exceptions when vesting may be allowed to continue or may even be accelerated are death or disability. Retirement is usually not one of the exceptions, but check your employer’s RSU plan documents to verify.
RSUs Tax Treatment
First and most importantly, RSUs are treated and taxed as earned income in the tax year they vest. The taxable amount is the current market price of your shares on the vesting date. They will appear on your W-2 and include the following:
- Federal taxes
- Employment taxes
- Social Security & Medicare
- State and Local taxes
Example: You have 800 shares that just vested. The price on the vesting date was $20. That means you have $1,600 of taxable compensation.
Problems arise when you have many shares vesting and the stock price is significantly higher.
Example: You have 2,000 shares that just vested. The price on the vesting date was $120. That means you have $240,000 of taxable compensation.
Yes, that’s an excellent problem to have, but there are tax ramifications. Remember, you have to pay earned income taxes on that compensation! Thankfully, many companies offer a way to pay taxes at vesting. You can surrender enough stock back to the company to cover taxes. It’s easy to avoid a large income tax bill come filing season.
Since you’re receiving RSUs, you are likely already a high-income earner. Adding your vesting RSUs to the equation increases the possibility of pushing you into a higher income tax bracket. You’ll need to plan ahead. However, fluctuations are possible since the taxable income is based on the stock price. It’s also problematic because the number of share vesting from year to year may change. This means adjusting your tax withholding annually, maxing out your, or your spouse’s, or both 401k, HSA, or deferred comp plans to reduce or offset this additional taxable income. Since HSAs and deferred comp plans can generally only be adjusted during the open enrollment period, it really becomes an annual balancing act.
Your RSUs Vested – Now What?
Now that your RSUs have vested, you own the stock. You must decide whether to hold your shares or sell them. The first step is determining the cost basis of your shares. The cost basis equals the market value of the shares the day they vest. Which also happens to be the amount that is taxed as your compensation.
If you sell immediately, there is no additional tax to the previously mentioned compensation taxes.
Example: You have 1000 shares that have vested. The price on the vesting date was $30. That means you have $30,000 of taxable compensation. Immediately upon vesting, you sell your shares. $30,000 (sales proceeds) – $30,000 (cost basis) = $0 capital gain/loss
If, however, you decide to hold your shares but still sell shares within a year of vesting, any gains are considered short-term and taxed at your higher income tax rates.
Example: You have 1000 shares vested on 12/15/2022. The price on the vesting date was $30. That means you had $30,000 of taxable compensation in 2022. You hold on to your shares but run into an emergency and sell your shares on 4/2/2023. The stock price at the time of sale was $35. $35,000 (sales proceeds) – $30,000 (cost basis) = $5,000 short-term capital gain, which is taxed as ordinary income at your income tax rate.
Maybe you have no plans to sell your shares. When you hold your shares for longer than a year before selling, the gains are subject to much lower long-term capital gains rates. Realized gains would be taxed at 15% or 20% depending on your taxable income.
Example: You have 1000 shares vested on 12/15/2022. The price on the vesting date was $30, which equals $30,000 of taxable compensation in 2022. You hold on to your shares but then decide to sell them to purchase a new car. You sold your shares on 2/12/2023. The price of the stock at the time of sale was $40. $40,000 (sales proceeds) – $30,000 (cost basis) = $10,000 capital gain taxed at the long-term rate of 15% (or 20%)
All of the above examples show what happens when the stock price increases and results in capital gains. If the stock price decreases, you can deduct the capital losses. First, the losses are applied to any gains, if any, and then can be applied to other taxable income, with a limit of deducting a $3,000 loss per year. If any losses remain, they are carried over to the following year or years, if necessary.
One item to be aware of is that many companies restrict when employees can trade company stock. It helps protect both of you against insider trading. You need to work that into the financial planning equation if you have trading windows.
Too many RSUs in one basket
Although RSUs are an excellent way to increase your wealth, there is a risk of holding too much company stock. If your employer is doing well and the stock continues to climb, that doesn’t mean you want to rely too much on the company’s success. Nobody can predict the stock market or the future fortunes of your employer. You need to protect yourself with a well-diversified portfolio.
Your job is usually a big enough ‘investment’ in one company. Retirement investments should be diversified.
Make sure your RSUs, if you’re holding on to them, fit into a diversified investment strategy. Be careful not to have too much of your net worth tied up with your employer. Do you remember Enron?
RSUs – living beyond your means
Don’t become reliant on RSUs to live beyond your means. You can’t predict the value of the RSUs at the time of vesting. Stock prices fluctuate, and sometimes not in a good way. Do not look at RSUs as a source to meet your living expenses. Use them as savings devices. Whether keeping them as stock or cashing them out and saving the proceeds elsewhere, it’s wise not to have RSUs pay the monthly expenses. Instead, use RSUs to increase savings, pay off debt, or both.
Planning For the Future
RSUs are an excellent employer benefit to help you retire, improve cash flow, pay off debts, or help achieve other financial goals. They can set you up for long-term financial success if used and planned for properly.
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