If you work at a tech company or a startup, you’ve almost certainly heard about restricted stock units (RSUs). But even larger, more traditional companies offer them — it’s an attractive option for any company that wants to offer a competitive employee compensation package without negatively impacting cash flow.
While RSUs can be very valuable (at some companies, they might even make up the majority of an employee’s compensation), they can also be difficult to understand. In order to incorporate RSUs into your overall financial plan, a solid understanding of them is key — that’s why we’ve created this thorough but easy-to-understand guide.
In it, we’ll address questions like “what are RSUs,” “how are RSUs taxed,” and more.
RSUs 101
Before we answer the question “how are RSUs taxed,” let’s do a high-level recap of the basics:
What is an RSU?
An RSU is a form of non-cash payment representing a share of stock in a company, which is granted to people who provide services for the company. New employees can be awarded RSUs as part of a job offer and can sometimes even negotiate the number of shares they receive, while current employees that are highly valued can be awarded more RSUs over time if they meet certain performance goals. It’s important to note that RSUs differ from stock options in that an option is not given to an employee in lieu of compensation; an option is the right to purchase a share of stock at a stated price, within a certain period of time. RSUs are a great retention tool for companies since the recipient typically must remain employed while the shares vest.
How do RSUs vest?
Typically, when you’re granted an RSU, it isn’t yours right away. It takes some time until those RSUs vest, or officially become yours. There are a few different ways that RSUs can vest:
- Graded Vesting
Graded vesting refers to a vesting schedule in which RSUs vest gradually over a period of time — at large companies, a four-year schedule is most common. Often, an employee must wait a certain amount of time (such as a year) before any RSUs vest at all. After that, the remaining shares will typically vest proportionally on a monthly basis.
Example: Lee just got a job offer at a company with a four-year graded vesting schedule. His RSUs won’t vest until he’s been with the company for one year, at which point 25% will vest. After that, the remaining 75% of his shares will vest at a rate of about 2% each month, until they have vested 100% after four years with the company.
- Cliff Vesting
Another (albeit less common) option is a cliff vesting schedule, in which all RSUs vest in one fell swoop after a certain period of time.
Example: Lee got a second job offer at a company with a four-year cliff vesting schedule. His RSUs won’t vest at all until he reaches four years with the company, at which point all 100% of them will vest.
- Performance-Based
The rarest vesting schedule is a performance-based one, typically reserved for high-level executives. According to this vesting schedule, RSUs will only vest once a particular goal or metric is reached.
Example: Maya was just hired as the CEO of a privately-owned tech company. She has been offered a large number of RSUs, but they will only vest if the company goes public.
Read More: If Equity Compensation is Part of Your Package, Here’s What You Need to Know
How Are RSUs Taxed?
Now that you’ve got the basics down, we can address the question: “How are RSUs taxed?”
Taxation Upon Vesting
As we mentioned earlier, RSUs don’t officially belong to you until they vest. At this point, they turn into shares of the company stock, which are taxed as regular income along with any other income you bring in.
Example: Dev works at a company with a four-year graded vesting schedule. After his one-year work anniversary, 25% of his RSUs vest — the total value of which is $30,000. Along with the $170,000 he earned in wages, his gross income for the year is $200,000.
How Are Stocks Taxed?
Once your RSUs vest and become stock, they aren’t actually liquid assets yet. If you want to convert them to liquid assets, you’ll need to sell them.
Taxation Upon Sale
If you sell your stock less than a year after it has come into your possession, it will be taxed at a short-term capital gains rate (10% to 37%, depending on your total taxable income). Hold onto it for over a year, however, and it’ll be taxed at the more favorable long-term capital gains rate (0-20%, depending on your total taxable income).
Note that although RSUs are taxed upon vesting and stock is taxed upon selling, it doesn’t mean you’re being “double-taxed” — when selling stock, you are only taxed on the difference between the value when you received it, and the value when you sold it.
Example: After Dev’s second work anniversary, 50% of his RSUs have vested and become stock. He decides to sell the 25% that vested the previous year. When that 25% was granted to him, the stock was worth $25,000, but he manages to sell it for $40,000. He is taxed on the difference — $15,000 — at a long-term capital gains rate since the stock was held for more than a year.
Read More: 5 Essential Elements of Tax Planning with a Financial Advisor
RSU Risks & Benefits
Odds are, you’ve heard stories of people who got in on the ground floor at a startup, received a significant amount in equity, and retired as multimillionaires after the company went public. But making RSUs the linchpin of your financial plan is not without risk. Consider that:
- You could leave or lose your job before your RSUs fully — or even partially — vest
- If your company were to shutter, your RSUs would have no value
- When RSUs vest, your taxable income increases, which can bump you up to a higher income tax bracket
- The value of your RSUs could go down over time
- Even if your RSUs do appreciate, they may not do so as much as you’d like
- Receiving RSUs from private companies brings additional complications:
- Private companies can lock up shares — i.e. bar holders from selling them — until they hit a milestone like going public or getting acquired
- You can’t sell stock for a private company as easily as stock for a public company, since there may not be an existing market for it
That’s not to say, however, that RSUs can’t be a part of your wealth-building strategy — it just might be worth taking some precautions.
Mitigating RSU Risk & Tax Liability
If you’ve been wondering “how are RSUs taxed,” you probably also want to know about strategies for mitigating the risk and tax liability associated with them. Here are four ways to do so:
Sell Enough Stock to Offset the Tax Increase
Because RSUs that vest into stock are taxed as regular income, they do carry a tax liability — particularly if they’re worth enough to bump you up to a higher tax bracket. If this is a concern of yours, you can sell just enough stock to cover the additional tax liability and hold onto the rest.
Reduce Your Taxable Income
Another way to mitigate the tax liability of RSUs is to reduce your taxable income. There are a number of different ways you can do this, such as by:
- Increasing your charitable giving
- Opening or contributing additional funds to:
- A 401(k)
- A traditional IRA
- An HSA
A financial planner can help identify the best tax reduction strategies for your situation.
Choose an 83(i) Election
If you’re granted RSUs from a private company, you may be able to make an 83(i) Election, which allows you to defer the income you get from RSUs for up to five years after they have vested, but how would one know if this option is available? To determine if you qualify for an 83(i) Election, it’s crucial to seek guidance from a tax advisor or financial professional who can assess your specific circumstances, such as the type of equity grants you’ve received and your eligibility based on the criteria set by the IRS. This is an especially good option if you know that your overall income is going to be lower in the near future — such as if you plan to take a sabbatical, leave your job to care for your family, or go from working full-time to part-time.
Diversify Your Portfolio
RSUs can certainly appreciate in value, and every once in a while, equity in companies like Apple or Tesla grows exponentially. But it’s rare for any one individual stock to outperform the market over time — so generally, it’s better to maintain a diversified portfolio.
If RSUs currently make up a significant portion of your portfolio — say, more than 10% — you may want to sell a portion of them and reinvest those funds into more diversified sources. That way, you won’t have too many eggs in any one particular basket.
Consult With a CERTIFIED FINANCIAL PLANNER® Professional
At this point, we’ve defined what RSUs are, answered the question “how are RSUs taxed,” and offered some strategies to mitigate RSU risk and tax liability. And while this is a great starting point, it’s only a brief introduction.
The truth is, RSUs are a complex subject, and the right approach for you will depend largely on your circumstances: your existing income, the value of your RSUs, your personal financial goals, etc. If you want help incorporating RSUs into your personal financial plan, Team Hewins would be happy to help.
Our team of CERTIFIED FINANCIAL PLANNER® professionals has years of experience helping clients with every aspect of financial planning, from portfolio management to retirement planning, estate planning, and more. Schedule a free consultation today to get started!