By Tom Burleigh, CFP®, CTFA® and Landon Fritch, CFP®

As organizations seek ways to align employees with the long-term success of the company, the popularity of Restricted Stock Units (RSUs) has grown. For many publicly traded companies, RSUs have become a key component of compensation plans. While private companies can also issue RSUs, they are less common and have their own unique considerations. This article focuses on RSUs for public companies.

Read on to learn more about RSUs and how you as an employee should evaluate this benefit as a part of your overall financial plan.

What are RSUs?

RSUs are more prevalent in larger, public companies where employer stock is available to be purchased or sold in a liquid, open market. When a company offers RSUs to an employee, it is “granting” a specific number of company shares, which are usually only available to the employee once certain vesting requirements are met. In other words, instead of outright grants of stock, the employee is receiving “units” that represent shares that are “restricted” by vesting requirements. The employee will not actually own any shares until they have vested, which is designed to create an incentive to remain on the job and work towards the success of the company. Upon vesting, the “restriction” lapses and the “units” turn into shares of stock.

By granting equity to the employee, a company can promote a culture of ownership and a shared financial incentive for the long-term success of the organization. While employees are free to sell the shares for cash upon vesting, the vesting period creates retention and productivity incentives in the meantime.

Vesting Schedule

A vesting schedule details the requirements that must be met for the employee to receive the shares. In many situations, time and continued employment are the main requirements. In other cases, the employee must meet certain performance indicators to receive the shares. Common performance metrics that are used include revenue growth, EBITDA, earnings per share, or return on equity.

One common example of a vesting schedule for time-based RSUs is a 4-year vesting schedule with a 1-year cliff. As an example, consider an employee who is granted 400 RSUs with such a schedule. The 1-year cliff indicates that 25% of the shares, or 100 shares, will vest after one year. The remaining 300 shares will vest over the final three years; they sometimes vest proportionally each year, on a freeform schedule, or monthly or quarterly cadences.

Either way, once shares vest, they become fully owned by the individual. If the employee leaves the company before the vesting period ends, they retain ownership of any vested shares. However, they are no longer eligible to receive the additional, unvested RSUs, as they have not met the time requirement. Exceptions do occur, such as in the event of retirement.

RSUs should not be confused with Restricted Stock Awards (RSAs), which are more common in private companies. With RSAs, the employee owns the shares when they are granted, but those shares can be forfeited if they do not meet the vesting terms. It is this distinction that makes RSUs ineligible for the 83(b) election, which allows them to pay taxes on the grant date instead of waiting until they have vested. It also means that RSUs do not receive any dividends or voting rights until they vest.

How are RSUs taxed?

No matter the form of compensation, understanding related taxation is a key component to understanding the true value of the compensation. In the case of RSUs, it is important to factor in taxation at the time of vesting as well as taxation at the time that the shares are sold.

Upon vesting, the value of an RSU is considered earned income from a tax perspective. Continuing the example above, let’s assume that at the one-year mark the company’s share price is $100/per share. Accordingly, the 100 vested shares are worth $10,000 on the open market. That $10,000 is considered taxable ordinary income in the year during which the units vested and would be taxed accordingly. The $100 per share price becomes the cost basis for the vested shares.

The second potential point of taxation, capital gains, depends on the length of time the shares are held. Consider upward or downward changes in the price of $100 per share:

• If shares are sold before the one-year anniversary of vesting, any gain would be considered short-term and taxed as ordinary income.
• If the shares are held for one year or more before selling, any gain would be taxed at more favorable long-term capital gains rates.
• If the share price falls below $100, the resulting loss would be considered short or long-term according to the same holding periods and would be treated accordingly.

Imagine the employee held their 100 shares and the stock price rose to $120. If all 100 shares were sold after one year for $120/per share, this would represent a long-term capital gain of $2,000 ($120 – $100 * 100 shares). Favorable capital gains tax rates provide additional incentive for employees to retain shares for longer holding periods.

Because RSU vesting creates an ordinary income tax liability, employers often withhold or sell some of the shares immediately to cover federal, state, and FICA taxes. Alternatively, if the employee prefers to keep all the shares, they can pay the taxes out of pocket. By default, taxes are withheld at the supplemental income rate set by the IRS, which is 22%. This can create a tax under-withholding for higher earning executives, especially those who fall into the 32%, 35%, or 37% personal income tax brackets. Those employees may need to pay estimated income taxes to make up the difference.

How to evaluate RSUs

At their core, RSUs are a lot like cash bonuses – with some bells and whistles. Selling shares immediately upon vesting can create cash windfalls for employees. Accordingly, for many employees, one big decision is whether to sell or hold their shares.

At this point, the decision becomes much more personal. For example, if cashflow is needed to cover general expenses or pay down debt, then perhaps selling shares at the time of vesting makes the most sense.

Beyond cashflow, risk tolerance and diversification are key considerations. Keep in mind that holding a significant portion of your investable assets in one company can be risky. As an employee’s salary and bonus is also tied to that company, a large stock position can create an even higher concentration of risk. A negative outlook for the company could impact both your portfolio and your cashflow.

This does not mean that you should sell all shares when they vest. Some individuals have the cashflow to cover expenses and the tolerance to accept the risks highlighted above. Investing in a single, fast-growing company can create significant value. If a middle ground is desired, an employee could take some risk off the table by selling a portion of shares at each vesting period, while retaining a portion for longer-term growth.

This leads to a final question: How confident are you in the financial future of your company? If you received a cash bonus at work and did not need the cash immediately, would you invest that money in your own employer? Or would you feel more comfortable with a diversified portfolio?  This is essentially the decision faced by employees at the time of vesting.

In summary

Receiving RSUs from your company is a wonderful benefit. With an understanding of the rules of RSUs, you can make an informed decision on how to approach the decision of holding or selling vested shares. This can also help determine the value of unvested shares if a career change is being considered.

Each situation is unique. An informed decision should consider the tax impact, diversification, and cashflow needs. Careful planning can ensure that RSUs serve as a tool to meet long-term wealth goals.

Up next: In our next installment in the Executive Compensation series, we will discuss the wealth-building power of employer stock options, We will discuss how to navigate taxes, vesting, and timing to maximize rewards.

Disclosures:

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