Welcome to the 1st edition of the Tech Financial Planning Newsletter.
In this newsletter, we will talk about what happens when they vest, the taxes associated, and what decisions you need to make.
TL;DR
In general, when RSUs vest, you gain full rights and ownership
When RSUs vest, you will owe taxes
Your company will withhold taxes, but depending on your situation, you might still owe taxes at the end of the year
To cover the tax withholding, you may consider a net, cash, or cashless exercise
After they vest, you need to decide whether to hold on or sell them
Intro
Restricted Stock Units (RSU) are a form of compensation granted by a company to its employees. In general, when your RSUs vest, you acquire full rights and ownership to the value of the units. Typically, this is transferred to you in the form of your company’s stock.
RSUs can be a great part of your compensation, but it’s important to understand their impacts on your financial plan.
Taxes on RSUs
When your RSUs vest, you will have to report compensation income to the IRS. As in most areas of life, the IRS wants a piece of the action, so you will be subject to taxes (federal, state, Social Security and Medicare).
Planning Note
It’s important to note that this is in the year your shares vest, not the year the shares are granted.
How do you figure out how much income to report? That amount will be equal to the number of vested RSUs you receive multiplied by the fair market value of the stock at that time:
Compensation Income = (FMV of the stock) X (# of RSUs received)
Example: You vest 10,000 RSUs at a time when the stock price is $10 / share. In this case, you would report $100,000 of taxable income. Here’s how we got there:
$100,000 = ($10 FMV) X (10,000 vested RSUs).
Planning Note
If your company has a situation where you pay something for the shares (other than taxes withholding), you will reduce the amount of compensation income by the amount you paid.
Example: You pay $10,000 for $30,000 worth of company stock. The stock is vested when you receive it. In this case, you will have to report $20,000 worth of compensation income.
So that you don’t get a huge surprise come tax time, your company is required to withhold taxes on the vested stock. As usual, the IRS requires tax payments in cash, not shares of stock.
You can think of it like receiving cash. Similar to a cash bonus or a paycheck, the amount of taxes paid must cover federal income tax (and state, if applicable) withholding plus the employee share of Social Security and Medicare tax.
For most people, your company will withhold 22% for federal taxes (as of writing this in 2022, this is the current rate, although this could change). If you have a high enough income, the withholding rate may be as high as 37%.
So what does this look like in practice?
Let’s assume a flat 22% withholding rate. we can project the total taxes due when your RSUs vest as:
(Taxes Due) = (Compensation Income) x (Tax Rate).
Taking the example above, how much would taxes be on your vested RSUs with $100,000 in compensation income?
$22,000 = ($100,000 Compensation Income) x (22% Tax Rate).
Please remember, there’s a decent chance that your actual taxes may be higher than the above example because of Medicare, Social Security, and state taxes (if you are in a state that taxes compensation income). For example, here in California, the tax on supplemental wages is a flat 10.23%.
How to pay for taxes
In our above example, you have $100,000 worth of RSUs. Depending on your tax situation, income, and the state you live in, you could owe $40,000 or $50,000 worth of taxes
So, how the heck do you pay for all this?
There are different options, but here are three of the most common:
Cash exercise - This means you will pay your company the full cash needed to cover the entire tax when your shares vest. This will result in you keeping the maximum number of shares.
Let’s say the taxes due were $30,000. You would pay $30,000 out of pocket so that you kept all your vested shares
Cashless exercise - This means that you would sell some of the shares so that you don’t have to come up with cash out of pocket to pay the tax bill. This is often referred to as sell-to-cover
Same scenario as above - the taxes dues are $30,000. You decide to sell 3,000 shares at the current share price of $10 in order to cover the taxes (3,000 shares x $10 / share = $30,000).
Net exercise - This means your employer (or whoever issues your company stock) to withhold the number shares required to meet the tax bill. They would then deliver the remaining shares to you at the time of transfer.
Similar to above - instead of giving you 10,000 shares at $10 / share and then you turn around and sell 3,000 to cover the tax bill, here the company would keep back 3,000 shares and only give you 7,000.
My company took out taxes - why do I still owe come tax time?
The tax bill you pay when your shares vest might not be large enough to cover the full amount of tax due on this income. You could end up owing come tax time even though you paid the withholding. This is because the amount your company withholds is merely an estimate of the actual tax liability.
I can’t emphasize this enough - just because your company withholds taxes to cover the bill, don’t assume that this covers your whole tax need. There is a very real chance you will still owe additional taxes come tax time.
If you are in the 32% tax bracket and your company is only withholding 22%, you will have to make up that missing 10% come tax time.
Let’s take an example where you receive the same $100,000 worth of vested RSUs (only looking at federal taxes)
Your employer withholds 22% at vesting = $22,000
Tax due is at 32% = $32,000
Potential taxes still due = $10,000
If you aren’t ready for that, it can be a big surprise!
This is why it’s important to know your tax situation so you can plan accordingly. For example, if you know your company isn’t withholding enough and you may owe, it could make sense to make an estimated tax payment when the RSUs vest.
Which is why it can be worth it to work with a CPA or advisor who specializes in RSUs and can help you with your numbers. Everybody’s situation is different, and we are only using hypothetical examples as illustrations, not recommendations.
Keep or sell your vested RSUs?
Now that your RSUs have vested, you have a big decision.
Should you hold onto them or should you sell them?
Perhaps the easiest way to answer this question is with another question.
Let’s say, instead of the $100,000 in stock, your company gave you a $100,000 bonus. Would you turn around and buy your company stock at the current market price?
If the answer is yes, then it probably makes sense to hold onto the stock. If the answer is no, then it might make sense to sell, especially if you plan to reinvest the money in a diversified portfolio.
Here are some other questions to think about:
How much of your net worth is already in your company stock?
A typical rule of thumb suggests that you shouldn’t have more than 10-20% in any single position. If you are significantly above this range, it probably is worth having a discussion with your advisor and get clear on your risk tolerance, dreams, and objectives.
It’s worth noting that everyone’s situation is different. A single 30 year old who is planning on working another 30 years is in a very different position than someone who’s 60, married, and wants to retire in the next 5 years. The 30 year old might be comfortable with holding onto a little bit more company stock.
Are you ok with potentially greater volatility?
A single stock will often move much more than a portfolio of stocks will. If you are someone who watches obsessively, this might cause too much stress and anxiety.
The highs could be higher, but the lows could be much lower.
If you decide to sell
If you decide selling is the right move, either now or in the future, there’s a few things you will want to be aware of.
First, when you sell the stock, your shares are treated as if you bought the stock on the date the company gave it to you (the day the shares vested), for an amount equal to the amount you paid (if any) plus the amount of compensation income you report.
It actually doesn’t matter if you paid anything for the stock. Another way of thinking about it: It’s like the company paid you that much cash and you used the cash to buy the stock.
Second, make sure you are aware of short term and long term holding periods. The holding period starts the day your shares vest. This matters because how long you hold onto your shares helps determine what taxes may be due.
Short Term - you have held the shares for a year or less
Long Term - hold it for more than a year
If you sell when holding for a year or less, you will have short term capital gain or loss on the sale. Short term capital gains are taxed at ordinary income rates.
If you hold it for more than a year, your gain or loss will be long term. Long term capital gains are taxed at preferential rates.
The gain or loss is the difference between the cost basis of the stock (aka the purchase price or the FMV of the stock you reported as compensation income) and how much you sell the stock for.
Planning Note
Often people think long term means a year or more but it needs to be greater than one year! If you sold on the one year mark, it would still be short term.
Example: You decide to sell $50,000 of your stock. We will continue our example where the restricted stock had a cost basis of $10 / share.
It’s easy to see that, depending on how long we hold our shares, our taxes can look very different.
Some other things to consider
83b
So far we have mostly discussed Restricted Stock Units (RSUs) but you may have Restricted Stock Awards. In general, the tax rules we have talked about cover both when they vest.
However, if you have restricted stock awards (not RSUs) you may want to consider the 83(b) election when they are granted to you.
The 83(b) election is where you choose to be taxed on your restricted stock when it is granted, not when it vests. The idea (or hope) is that the value of the stock is higher when it vests than when it is granted to you. If this turns out to be true, you will likely have paid less in taxes.
There are two key, potential downsides. The first is the opposite of the above - the value of your stock actually decreases from granting to vesting. If this happens, you will probably paid more in taxes than you needed to.
The other is that you are paying taxes that you don’t own yet. If you forfeit the shares prior to vesting, you will have paid taxes on something you never owned. One example where this could play out is lets say, before vesting, you get an incredible job offer you accept. While the potential for the new job may be amazing, you just paid taxes that you didn’t need to.
83(b) elections are tricky and there are big potential risk/reward trade offs. If you are considering this, it probably warrants speaking with a professional.
Cashflow
Depending on where you are at in your life and what is coming up, the sale of RSUs could provide some much needed cashflow. For example, if you need cash for some home remodels, college, or a sweet vacation, you could consider a cashless exercise of some / all your shares.\
You can use the resulting cash to fund your other dreams.
Cashless income
A common misconception is sometimes people think about income as money they’ve received. Unfortunately, this isn’t the case here. You have to report income, and pay the associated taxes, even if you haven’t sold the stock.
You didn’t receive any cash, and you may have actually paid cash to get the stock, but you have to come up with cash to pay the IRS! Careful planning is required
Blackout / lockout periods
From a compliance perspective, you will need to understand whether you are able to sell your stock or not. Here are some situations that could apply
Your company recently went through an IPO (or is about to)
Those with inside information may be locked out of selling during certain time periods
If you are an executive, you could be tied to a 10b5-1 plan
Final thought
Everybody’s situation is different, but RSUs can offer a great opportunity to increase your wealth. Make sure you take the necessary care, time, and planning to make the best choices for you and your family.
Any information contained above should not be construed as tax or legal advice and is provided solely for your convenience. Tax and legal questions should be directed towards your respective tax and legal professionals. This document may contain “forward-looking statements” – that is, statements related to future events. The use of words such as "expect," "anticipate," "intend," "plan," "believe," "seek," "see," "will," "would," or "target" suggests that potential outcomes are uncertain and actual results may vary materially. Past performance is no indication of future returns and investments can contain significant risk. Losses are always possible, especially over shorter time periods, after periods of extended positive returns, and in specific individual securities. Hypothetical examples contained herein are for illustrative purposes only and do not reflect, nor attempt to predict, actual results of any investment. The information contained herein is taken from sources believed to be reliable, however accuracy or completeness cannot be guaranteed. Please contact your financial, tax, and legal professionals for more information specific to your situation.