Our previous article about equity compensation covered Employee Stock Purchase Plans (ESPPs).
Today, we’re going to dissect a prevalent vehicle that pops up in compensation packages across industries, Restricted Stock Units (RSUs).
As part of our “Equity Compensation Foundations” series, this article covers the critical mistakes employees make with their RSUs and how to leverage them appropriately as part of a comprehensive financial strategy.
What Is An RSU (And How Are They Taxed)?
RSUs are a form of non-cash compensation that represent a promise of company stock.
You receive the stock once you reach specific time or performance metrics. For example, your shares may vest once you’ve been with the company for a specified period or when the company surpasses particular income thresholds.
RSUs offer innumerable benefits once they vest but don’t hold tangible value before then. Since you don’t own the stock, your RSUs won’t come with voting rights or control over the vesting timeline.
How And When Employees Get Their RSUs
RSUs vest over a predetermined period based on a vesting schedule and/or other performance milestones. Once you achieve those key events, you have access to the stock, which you can then hold or sell.
RSU vesting schedules are critical to understand, but each company structures them differently. Let’s look at an example.
You’re granted 1,000 RSUs that vest over 4-years with a one-year cliff.
Now, what does that mean?
In this case, 250 shares, or 25%, would vest after the first year. After that, your remaining shares could vest monthly, quarterly, semi-annually, or annually until the 4 year period is complete. For simplicity, let’s assume that the shares vest annually, meaning 25% of your shares will vest each year.
Additionally, if you stay with the company long enough, you may get RSU “refreshers” (or additional units).
Key Dates To Consider With Your RSUs
Like most forms of equity compensation, there are many dates to consider (and terminology to go with it). Here are the most important ones:
- Grant Date: The date your employer offers you RSUs.
- Vesting Date: The date(s) on which an employee has achieved the requirements or passed the milestones (restrictions) inherent within the RSU Plan, and the shares become available.
RSUs and Taxes
RSUs are another form of compensation, and therefore, come with tax implications you’ll want to understand completely.
Here is a high-level list of how RSUs are taxed:
- RSUs are taxed as ordinary income as they vest.
- If the shares are sold immediately, there is no capital gain, and you only owe tax on the RSU-produced income.
- Shares held after vesting are taxed at short- or long-term capital gains, depending on when they are sold.
To understand RSUs more simply, it is helpful to think in terms of a cash bonus. As soon as your RSUs vest, the IRS views that as an extra payday, whether you hold or sell the shares.
Four Common RSU Mistakes To Avoid
RSUs can get complex, and it’s easy to fall into some common investor traps. Here are four mistakes many investors make with RSUs and how you can avoid them.
#1 Concentration In Company Stock
Being too heavily concentrated in company stock is a typical risk with any equity compensation, especially RSUs, since you automatically receive the shares once they vest (a fundamental differentiator from stock options).
Your portfolio takes on more risk when one (or a handful) of assets are over-represented. Why? Your investments aren’t as diversified and therefore become much more susceptible to market swings—both highs and lows.
Additionally, since you work for the same company through which you’re compiling equity, your income must also be pooled into your concentration risk. If your paycheck and your portfolio rely on one source, it’s time to take another look at how you’re investing.
Remember, RSUs are akin to receiving a cash bonus. Ask yourself, would you use your entire bonus to purchase company stock? The answer is likely no; you’d probably aim to diversify into more balanced avenues like retirement, education, and other investment goals.
#2 Not Paying Attention To Your Vesting (and Taxing) Schedule
Vesting schedules are perhaps one of the most critical planning opportunities for your RSUs, and they are not created equal.
You need to understand your specific vesting schedule and how the key dates impact your tax picture.
First, RSUs are taxed as ordinary income as they vest. This means you’ll be taxed on the fair market value of your vested stock. Let’s return to the example at the beginning of the article to help illustrate this point.
- 25% of your stock (250 shares) vested on September 15, 2021.
- The stock price on that day was $15 per share, meaning you have to report an extra $3,750 of income on your tax return.
This example leads into a follow-up question: how will you pay the tax bill?
There are a couple of options to consider. You could plan for the vested stock and stash away more cash, or you could sell at least enough of your shares to cover your tax bill.
The right decision for you ultimately comes down to your unique investment situation. If your RSUs result in a significant windfall, it may be prudent to plan for it by selling off enough shares, so you aren’t stuck with a massive bill come April.
Creating a comprehensive plan can help you avoid paying too much in taxes and enable you to use the money in ways that will support your goals.
#3 Relying On RSUs To Cover Cash Flow Gaps Or Big Expenses
While your RSUs are added compensation that can help you achieve your financial goals, relying on the income for regular cash flow is a slippery slope. RSUs are equity, and as such, are tied to the ebbs and flows of the market and your company’s performance, making it too volatile for consistent spending.
All this means is that you shouldn’t “bank on” your RSUs to fulfill a real cash need at a specific time. Say you have a goal to purchase a vacation home and want to secure funds for a down payment. Your RSUs may be able to help, but you may also have to be flexible with your timeline if the value of your stock declines.
#4 Holding Your RSUs Because You’re Unsure What To Do With Them
When it comes to your RSUs, avoiding action can lead to negative financial impacts. How so?
First, you open up yourself to high concentration risk. Too many eggs in one basket brings undue risk to your overall portfolio.
Second, and perhaps most importantly, not taking action can result in a higher tax liability. You want to use your RSUs in a tax-efficient way that aligns with your investment goals, and inaction can be a decision that costs you in the long run. Since everyone’s situation is different, it’s best to create an intentional plan for your unique needs.
Creating A Plan For Your RSUs
Cultivating and optimizing a strategy for your RSUs is critical for long-term financial success.
Here are a few fundamental tips for a solid RSU strategy:
- Knowing when to hold and/or sell your RSUs when they vest.
- Understanding how your RSUs are taxed and preparing accordingly
- Knowing how ongoing RSU grants and refreshers impact your financial plan
We Can Help Create A Plan For Your RSUs
RSUs can play a significant role in your financial plan. Given their weight, it’s vital to build a strategy that considers your entire financial picture so you maximize the benefits.
Understanding the type of shares you have, when they vest, and their tax consequences helps you make informed and intentional decisions that put you on the path toward your goals.
At Wingate Wealth Advisors, we’re experts at guiding our clients through their equity compensation. We want to help you create a strategy that complements the rest of your financial picture. Contact us today.
