Restricted Stock Units have become the most popular type of equity compensation, especially in tech sectors, even surpassing stock options. This means that the demand for financial advice on RSUs is increasing, especially in retirement and tax planning. But what are RSUs? How do they differ from stock options and Restricted Stock Awards? What are the tax implications of RSUs? And do they impact Social Security? Here's what you need to know to help you make the most of RSUs.
The RSUs Basics
Simply put: Restricted Stock Units (RSUs) are a company's commitment to give an employee a set number of shares when certain conditions are met. RSUs are not the same as company stock. Instead, you receive units that are exchanged for real stock at a later date. Unlike stock, RSUs have no value until they become "vested."
RSUs are given a fair market value as soon as they vest but - as the name suggests - are "restricted" from sale for a fixed period (usually one year) before the employee fully owns them. Some employers may also require employees to hold their stock after it becomes vested in order to qualify for full benefits such as voting rights or dividends. This is called a "lock up."
One of two types of conditions must be met before RSUs vest: time-based, or performance-based. Time-based vesting schedules are often tied to length of employment where shares vest over time (commonly three years).
However, an increasing number of companies are making vesting conditions something other than time-in-service (especially for high responsibility roles like executives, or where the employee has a crucial role in shaping the future direction of the company). In this case, they typically tie it to performance, or when a company reaches specific goals such as:
- when a company goes public, or
- when a company is sold
What happens if I leave the company before I'm vested?
Employees usually must keep working for the entire duration of the vesting schedule before they become eligible to receive the benefit of their RSUs. Otherwise, they risk losing the right to claim some (or all) of their shares.
Although there are circumstances where vesting may continue - such as a disability or forced retirement - you should review the RSU plan to ensure that you understand the ramifications of leaving. In some cases, executives can negotiate a continued vesting schedule after they have left the company into their retirement or separation agreement.
While RSUs can provide employees with the opportunity to share in the success in the company's interests, there are advantages and disadvantages to this type of equity.
What are the Advantages and Disadvantages of RSUs?
Advantages for EmployERs:
- Attracts new hires and rewards loyalty.
- Increases staff retention and stability.
- Employees are more incentivized.
- Provide compensation without paying upfront.
Advantages for EmployEEs
- You receive compensation in the form of stock shares.
- You own the shares at their market value after they vest.
- Your return may be higher than anticipated, and more than a raise or bonus paid in cash.
Disadvantages for EmployERs
- The ultimate value of the stock to your employees is unknown.
- It may not be sufficient to reward or incentivize staff adequately.
Disadvantages for EmployEEs:
- The value of the stock may not be as great as expected.
- If you leave, you may forfeit all or some of the remaining shares to the company (depending on your vesting schedule).
- RSUs hold no intrinsic value until they are vested.
- Unlike stock, RSUs don't provide dividends or voting rights.
Are Stock Options and RSUs the same thing?
Stock options are another form of equity-based compensation, but they differ in significant ways. Simply put, while RSUs guarantee employees a certain number of shares in the company when certain conditions are met, Stock Options give employees the right to purchase shares at a future date at a predetermined price. T
his is price is usually higher than the current market value. The idea is that if the company performs well, the price at the time of issue is a bargain. Employees use their own funds to purchase stock at this discounted rate. Usually, employees still need to be vested.
What about RSUs and Restricted Stock Awards (RSAs)?
RSAs are more similar, with one major difference: vested employees may have to pay upfront to receive their compensation when the conditions are met. RSAs are not as common, and they entail greater risk for employees because they must contribute funds before shares can be claimed. RSAs are sometimes offered when companies cannot afford to pay upfront and instead opt to provide equity by granting RSAs once goals are achieved.
While RSAs generally provide dividends and voting rights, they also come with complex tax obligations. Unlike RSUs (which have no tangible value until they are vested), you pay upfront and own RSAs outright when they are granted. RSUs don't have any tax liability until it vests (at which time it becomes income). The tax obligations can be complicated and perplexing, so ensure you consult with a financial advisor before accepting equity-based compensation to understand better what you're getting into.
Paying Tax on RSUs and RSAs
First, let's be clear: any time your company pays you — whether in salary, benefits, or equity — you owe taxes on that income. You can expect to pay federal income tax, state/local taxes, Social Security, and Medicare. One of the disadvantages of RSUs is that because they aren't tangible property, you can't pay tax on them until the shares vest, unlike RSAs.
"Why would I volunteer to pay my taxes early?" you ask. Because making an early 83(b) election on RSAs can reduce the taxable gain on the fair market value of the shares. If you're sure the stock will go up between grant and vesting, paying taxes on the lesser value might be a smart decision.
However, with RSUs, you could wind up in a limbo period between the vesting of your shares and the restriction to sell them (during which time the shares are considered 'illiquid', yet still taxable). But that's something you can offset by surrendering some of the company shares to cover the associated taxes. In fact, it's common to have your employer liquidate some shares to set against withholding tax and give you a net grant.
Do I sell or hold onto my shares?
It's worth remembering that capital gains tax rates are generally lower than ordinary income tax rates. It can be very tempting to hold onto shares and resist selling. However, diversifying and keeping the percentage of your portfolio invested in a single stock under 10% can help reduce risk. This is where getting guidance from a fee-only financial advisor on equity compensation can potentially save you from making expensive mistakes. Make the most of your RSUs and RSAs by learning about the tax implications of equity compensation, and plan accordingly!