We continue to talk to more people who are compensated by their employers with Restricted Stock Units. This form of compensation allows companies to incentivize their employees by granting them ownership in the firm. This is known as equity compensation, which is provided alongside base salary, bonuses, and other benefits. The common types of equity compensation are stock options, restricted stock units (RSUs) and performance shares. In this post, we explain what RSUs are and how they affect your taxes.

What are RSUs?

A restricted stock unit is a promise by your employer to grant you stock in the company at a specific point in the future. The stock is 'restricted' because it will be available to you after you meet certain conditions. The most common condition is simply to remain employed with the company over a time frame known as the vesting period.

Vesting is the process of earning an asset, benefit or future payment. The date your company offers you RSUs is called the grant date, and the shares are not immediately available to you like the shares of a company you've purchased on the open market. The number of shares and the future dates when RSUs will vest are determined when the RSUs are granted, but you don't own the shares until the conditions for vested are met.

As an example, let's say your company grants you 2000 RSUs and the shares of the company are trading at a market price of $20 per share. This will make your RSUs worth $40,000. You don't yet own the RSUs, but they will become available to you based on your employer's vesting schedule.

How long is the vesting period?

Typically, companies have a vesting period of four years but it can be as short as one month. The vesting period gives employees an incentive to stay with their company until all the shares have vested, since you must remain with your employer to access your RSUs at the end of their vesting period.

Typically, a portion of the shares will vest each year, starting one year after the grant date. In our example above, your employer might vest 25% of the shares or 500 shares each year. Another common practice is to front-load the vesting with more shares vesting earlier in the vesting schedule, say 35% after one year, 30% after two years, 25% after three years, and 10% after four years.

The other type of restriction has to do with your work performance. Your company may offer performance-based RSUs, which means you have to meet specific pre-established financial performance objectives over a specified performance period to own the stock.

How are RSUs taxed?

Restricted stock units are considered supplemental income and subject to ordinary income tax. If you choose to sell your RSUs after the vesting period, and make a profit above the vesting price, you will be liable to pay capital gains tax on the profit.

The value of the stock at vesting needs to be reported on your W-2 in the year you take delivery of the shares. Companies generally sell a portion of the shares that vest to pay required income taxes, just like they withhold a portion of your paycheck for taxes. The federal withholding rate is a flat rate of 22% on the first $1 million of RSUs (37% above $1 million). This can become a very significant tax problem if you are in a high tax bracket and have a significant amount of RSUs vested in a tax year.

The highest federal tax rate is 37% which is 15% more than the 22% withholding rate. If you are highly compensated via RSUs then you could owe 15% of the vested amount when taxes are due the following year. If your company stock rises, you can just sell shares when the taxes are due to pay the tax bill, but if it falls you might end up selling much more than 15% of the shares that vested to cover the tax bill. In an extreme case the value of the shares might have dropped to the point where you can't cover the tax bill by selling the remaining vested shares.

What to do with RSUs once they vest?

Going back to our example, when your shares vest, they are assigned a fair market value. That is, if your company's stock is valued at $50 per share when your first 500 RSUs vest after one year, they will be worth $25,000, which is $15,000 greater than the initial grant value. This total amount of $25,000 will be taxed as ordinary income in the year the shares vest. It is also possible that your company's stock may be languishing due to weak financial performance or a poor economic climate. If the stock price has fallen to $10, your taxable income will be $5,000, or the current value of the 500 shares.

One additional thing to remember is that RSUs are not guaranteed income. If you are no longer with your employer, you will not receive the unvested RSUs. Finally, having your employment, future income, and a large portion of your investment portfolio tied to a single company is a significant concentration risk. Building a diversified investment portfolio to minimize this concentration risk often means selling RSUs when they vest to help you achieve your long-term financial goals without undue risk. A qualified financial planner can help you make an informed decision.

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Jason Draut, CFP®
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Chris Sheehy, CFP®
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