How are RSUs taxed?
Heard of the term “carrot on a stick?” Substitute the “carrot” for Restricted stock units (RSUs) and you already know more than the next person. All jokes aside, RSUs are one of several forms of equity compensation that companies use to incentivize their employees for performance, tenure, or both.
What follows is a general overview of RSUs, a basic understanding of how they are taxed, and how to make the passing of the carrot a bit more “tolerable.”
A word of caution: do not attempt at home unless you’re under expert supervision, or at the very least, the supervision of a tax professional.
The Basics of Restricted Stock Units (RSUs)
From a top down view, most RSUs will have two key bits of information:
- Quantity – How many shares?
- Vesting Schedule – How long before you actually own the shares?
While quantity is straightforward, the vesting schedule can take any number of forms. As an example, let’s assume an employee by the name of Jamie has 500 shares of ABC stock on a 5 year graded vesting schedule. In layman’s terms, Jamie’s RSUs look something like:
In essence, a graded vesting schedule parcels out the shares piecemeal over the course of the five years.
It should be noted that other forms of vesting schedules can include:
- Cliff Vesting – another way of saying you don’t own a thing until the end of the cliff. For example, a 1 year cliff means you won’t own any shares until the end of that first year.
- Performance Based Vesting – can be tied to performance of the company and/or stock
For purposes of this article, we’ll focus on a graded vesting schedule.
What happens when I actually receive the shares?
Fleshing out the picture a bit more, the day the shares actually become yours is also known as the vesting date. Now the fun starts, as you will likely have several things to consider.
Upon vesting, RSUs become taxable to you as ordinary income. The value of this taxable amount is fairly straightforward, since unlike stock options, RSUs almost always have some built in value.
In the example above, if after the first year Jamie receives 100 shares of ABC stock and the price of said stock on the award date is $10; then $1,000 will be recognized as ordinary income. This will be in addition to any other wages and salaries collected throughout the year.
What are some of the risks involved with RSUs?
One of the main risks associated with RSUs is the tax risk. As with any form of equity compensation, RSUs will fluctuate in value. A lower stock price would mean that your total compensation is lower than in other years. Conversely, a higher stock price could mean a potentially higher tax bill – potentially bumping you from one tax bracket to the next.
Another potential risk is your expected value of the stock. If you’re near a vesting date and have plans for the money – only to see the stock price plummet – it could put a damper on your plans. This is where cash flow planning and projections become extremely important. In essence, you should avoid tying an important event to the value of the stock.
Set on building an outdoor pool with proceeds from the stock? Sure! Worst case, you can always push that back a little further.
Need to pay Juniors tuition with those same funds? Probably not a good idea.
How are the taxes paid?
The good news is that most companies help facilitate the estimated taxes through a variety of methods, including a withholding of shares (net settlement), sell to cover, or a cash payment. The goal of these is to make sure you don’t get surprised with a giant tax bill at the end of the year.
In the instance of share withholding, if for the sake of argument the estimated tax due is projected to be 30% of the vested shares, an employee would retain 70 shares while 30 revert back to the company. Several other options exist, the specifics of which should be confirmed with your plan details.
Assuming the tax situation has been squared away, you’re now left with shares of the company you work for. If you’re just starting out, it may not be a big deal since the amount you’ve accumulated may not be sizeable.
If however, you’ve been in the workforce for any extended period of time, the value of these shares can add up. So will the overall value of these shares as a part of your net worth. Be careful to not have too much concentration in any one company/industry. I recently wrote an article that discusses some of the pitfalls and how to potentially reduce this exposure.
But before you go selling shares to reduce equity concentration, be sure to know what Uncle Sam will expect from you.
If you hold and sell your shares within a year – you’re back on the same boat and the proceeds are considered short term capital gains – usually considered ordinary income.
Choose to wait more than a year? Good for you – any gains are taxed at the potentially lower long term capital gains rates.
There’s no right or wrong, but you’ll want to take special consideration and make the best use of your dollars. I’ve outlined some strategies here.
This article is by no means comprehensive – equity compensation is littered by details that can easily leave you confused. As always, consult your investment and tax professionals if you’re unsure as to the workings and ramifications of your equity comp. Need help? Set some time to chat here.
Sources: www.mystockoptions.com , www.investopedia.com