These two types of equity compensation differ in terms of their vesting schedule, how employees receive shares, and tax implications. This article covers restricted stock units, if you want to learn about stock options click here.
Restricted stock units (RSUs), which are distinct from stock options, are a form of equity compensation employers offer employees that require a vesting period before they are converted to common stock. Because they are not distributed up front, this form of equity compensation is said to be “restricted.” Recipients have RSUs issued to them according to a vesting plan and distribution schedule typically based on tenure milestones with the employer or performance accomplishments. It’s important to note that RSUs are grants of stock, so you don’t need to purchase them as with exercising stock options.
Though restricted stock units provide employees with a stake in their employer’s equity, their effective value only materializes upon vesting. When they vest, they are assessed and given a fair market value (FMV). To get an FMV, private companies must receive a 409A valuation via independent appraisers who examine factors such as how much a company’s assets are worth, the present value of future cash flow, and how much common stock is worth at comparable companies.
Private companies must receive a new 409A valuation each year or every time there’s a significant event such as a funding round or acquisition. (The FMV of most public company stocks can be found simply through the publicly listed share price.)
It can often be hard to decide what to do with your RSUs, particularly when selling the RSUs can result in a capital gains tax bill but it’s always worth considering diversification and tax-loss harvesting in your RSU planning.
When you’re working full-time for a company, the majority of your income is likely arriving from your salary. When you are receiving equity compensation, another significant portion of your livelihood is tied to the performance of that company. With so much of your financial life tied to one source, it’s important to consider the importance of diversification in financial planning to avoid concentrated risk if the company under performs.
By selling your RSUs once they’ve vested and saving your capital gains or investing them in another source such as an ETF or a retirement account, you may be better able to endure periods of market volatility by not tying the performance of your financial house to limited sources. Of course, if you do work for a larger tech company, for instance, be sure that the ETF does not have a large percentage invested in your employer. Investment allocation can be difficult to manage so it’s always worth speaking to an expert.
Once vested, RSUs are considered supplemental income. As such, some of the shares are withheld to cover income tax – something employers will typically handle on behalf of employees. Shares are subject to a federal withholding rate of 22% for supplemental income up to $1 million and 37% for income in excess of that (you may be on the hook for more in tax liability depending on your taxable income in a given year). After vesting, you'll own the remaining shares. You can then choose to keep (hold) them like any other company stock or sell them. Holding the shares for at least one year after they vest qualifies them for long-term capital gains tax rates, which are typically lower than short-term capital gains tax rates.
Selling your shares right away gives you cash now (liquidity), but you miss out on any future price increases.
It’s important to remember then, when your RSUs vest, you’ll owe taxes on their value. This might bump you into a higher tax bracket and limit some tax benefits, like contributing to a Roth IRA or getting certain tax credits.
One way to minimize taxes on RSUs hinges on selling them the shares immediately upon vesting. You’ll be on the hook for income tax but will not incur capital gains tax. That said, you will forfeit the opportunity to reap the rewards of upside growth.
To minimize taxes on RSUs, hold your shares for at least one year after your exercise date before selling them in order to qualify for long-term capital gains tax. Short-term capital gains trigger ordinary income tax. Long-term capital gains, by contrast, are taxed at 0%, 15%, or 20% depending on your marital status and taxable income.
Another option is tax-loss harvesting - link to article - this can be a great way to reduce the total capital gains tax you pay. Tax-loss harvesting can be a difficult concept to speak to an expert (CTA) to see if this is right for you.
Once vested, RSUs are considered income. As such, some of the shares are withheld to cover income tax. The remaining shares go to the employee, who is allowed to hold or sell them just like any other company stock. Work with a financial advisor to determine when to sell your shares and how best to reduce your tax liability.
Restricted stock units are granted to employees over a set vesting schedule without the need for them to purchase shares. Once the RSUs are vested, an employee can hold or sell the shares as he sees fit.
By contrast, stock options allow an employee the “option” of purchasing shares of the company at a predetermined price. If the share prices increase, the employee can purchase shares at the strike price and sell them when the share price has increased and before the expiration date.
Public companies, private companies and startups may provide equity compensation. Newer firms may want to allocate cash to other growth initiatives and thus offer equity compensation as a way to lure top talent and reduce their cash outlay. Though RSUs are particularly popular within the tech industry and companies in the FAANG gang, companies in a whole host of industries use them to compensate employees. The likes of Starbucks, Apple, Uber, Amazon, Verizon, Microsoft, IBM, Facebook, Intel and Bank of America use RSUs.
