Restricted Stock & RSUs: 3 Planning Tips
Equity compensation is becoming more mainstream and is not just for executives anymore. Grants of restricted stock or restricted stock units (RSUs) are getting to be more common than stock options ‚Äì and the rules are different, as is the tax planning. Below we will look at some of the particulars of how restricted stock and RSUs operate, how to understand a grant, planning for the tax consequences, and what to do after the shares vest.
How Restricted Stock and RSUs Work
At their core, restricted stock and RSU company shares that vest according to a schedule can be awarded as compensation. The vesting schedule can be tied to the length of employment, meeting certain performance criteria, or a combination of both. Upon vesting, the employee owns the shares themselves and can do what they wish with them ‚Äì from holding, selling, gifting, etc. While this might sound simple, the devil is in the details.
Understanding Your Grant
First, it is important to understand that restricted stock or RSUs are similar to stock options but have important tax and financial planning differences.
There are important facts you need to determine. First, how does the vesting schedule work; what amount of shares vest and when? Is the vesting simply tied to the length of service or are there performance or even liquidity event triggers? Second, what are your tax-withholding choices?
From there, you can determine, or at least estimate, key factors such as how much the award will be worth both pre-tax and post-tax.
Tax Planning ‚Äì Section 83(b) Election
Taxation can be tricky with restricted stock and RSUs. One strategy is to use a Section 83(b) election for restricted stock.
Typically, a person is taxed when the restricted stock vests, regardless of whether the shares are sold. The Section 83(b) election allows the taxpayer to be taxed on the share value at the grant date instead. This election can be made within 30 days from the grant date of the restricted stock and is not an option for RSUs.
Why would you want to consider a Section 83(b) election? Remember that regardless of the election or not, you are taxed as ordinary income for the share value regardless of whether you hold or sell the shares. The advantages are that if you think the stock price will rise between the grant and vesting, then you will pay less ordinary income tax and have lower cash outflows. Second, after the initial taxation of the grant, the change in value after this point is capital gains.
Tax Planning ‚Äì Withholding
The other issue to consider is not withholding enough taxes. The IRS rules say that your company is required to withhold 22 percent for restricted stock and RSUs (37 percent for income over $1 million during the same year).
The problem is that there is a good chance your margin tax bracket is higher than 22 percent if you are receiving these kinds of equity compensation awards. As a result, you will need to make some estimated payments to cover the difference. Unless you have enough cash from other sources, you may need to consider liquidating some of your shares to cover the tax bill.
The conundrum here is that if you do not see the shares immediately and the price falls, then you will be selling shares at a lower value than what you are being taxed on. It is best to consider your holistic tax scenario and work with your tax advisor to come up with a plan.
Game Plan for After Vesting
Aside from the tax consequences, you need to consider the impact on your overall financial planning. One of the biggest risks taxpayers can face is that they become heavily concentrated in the company stock. You will need to look at your overall portfolio and consider if you need to diversify depending on how much of your net worth is tied up in a single stock now.
Some financial planners recommend looking at the situation this way in an example with your shares worth $150,000 at vesting. If you had $150,000 in cash to invest, pay down debt, etc., would you use all of that to buy the company stock? If the answer is no, then why would you hold it? In other words, do not let tax implications lead your financial planning decisions.
More and more companies are issuing compensation in equity forms such as restricted stock grants or RSUs. Make sure you understand your vesting schedule and conditions so you can plan for the tax implications as well as your overall financial picture.