Just as a single piece in a puzzle can be difficult to decipher all by itself, a Restricted Stock Unit (RSU) can be a bit of a head-scratcher as a stand-alone asset.
In isolation, RSUs are simply a form of equity-based compensation; your employer makes a grant, or a promise, to give you company stock shares under certain conditions. That’s nice. But if you’ve been offered this benefit and you really want to make best use of it, it’s worth considering it within the bigger picture of your overall investment portfolio.
First, let’s cover the basics. Then we’ll view how RSUs fit into your total planning puzzle
In most cases, granted RSU shares vest and become yours after a minimum tenure with a company. Vesting schedules vary:
- Cliff vesting: All granted shares are delivered at once.
- Graded vesting: You become vested in portions of the granted shares over regular intervals.
- Hybrid vesting: Your employer may offer a mix of cliff and graded vesting. For example, they may grant shares that vest over four years, with 25% vesting after the first year and the rest vesting in equal monthly installments over the next three years.
While RSUs have an estimated value at the time of grant, the actual value to you depends on your shares’ fair market value when they vest. Let’s look at an example:
Emmitt is offered a compensation package of $75,000 in salary and a grant of 4,000 RSUs vesting quarterly over the next 4 years (250 shares per quarter). The shares currently trade at $25. So this year, Emmitt’s annual cash and equity compensation is estimated as $100,000.
If the share price is higher than $25 at the vesting date, the value of Emmitt’s actual compensation increases. Similarly, his compensation decreases if the share price declines by the vesting date.
Taxes are another critical, and often misunderstood piece in effectively managing your RSUs. Let’s look at that next.
Taxes Due Upon Vesting and Sale
There is no tax at the time of grant since the shares are not technically yours yet. But as you might guess, the IRS does get its due in due time.
- Upon vesting: In the year your RSUs vest, their share value is considered ordinary income, taxed just as if you had received the same amount in cash. Even if you do not sell them, the share value is subject to federal, payroll (Social Security and Medicare), and applicable state and local taxes for that year.
- Upon sale: After that, any change in value from the vesting price is taxed as a capital gain or recognized as a capital loss once you do sell the shares. (Note: If you vest and then immediately sell your shares, it stands to reason that you incur neither a gain nor a loss.)
Taxes Withheld May Not Suffice
Upon vesting, your employer may automatically withhold shares to cover your taxes. RSU income is subject to mandatory supplemental wage withholding for federal income tax purposes. That’s 22% on the first $1 million of supplemental wages and 37% once it exceeds $1 million in a calendar year. State tax rules vary, but they often have their own mandatory withholding rules.
But there’s a catch. The actual tax you’ll owe on RSU income can be much higher than these standard withholding rates. And if you underpay, you risk incurring tax penalties. As such, you may want to pop for a tax projection, to determine the appropriate amount to either have withheld or to pay as estimated taxes.
To understand the tax ramifications, let’s continue with Emmitt’s example.
Emmitt is expecting 250 RSUs to vest shortly. Assuming his company stock is trading at $25/share when they vest, he owes ordinary income tax on $6,250 (250 x $25) that year. If Emmitt sells the shares immediately after vesting, there is no additional tax to him. If he sells the shares for a gain in the future, the gain will be taxed at the capital gains tax rates. If the price declines, Emmitt will recognize a capital loss when he sells the shares.
Busting a Tax-Planning Myth: Holding Does NOT Help
We typically see employees hold RSUs after they vest for two inaccurate reasons. First, they mistakenly think there are tax advantages to holding RSU shares after they vest. The truth is: There is no tax benefit to holding the shares beyond the vesting date.
As described above, RSUs are almost always taxed as income in the year they vest. In other words, whether Emmitt receives $100,000 in salary, or a combination of salary and RSUs, the tax liability is the same. Unlike with ESPP shares, you cannot reduce this liability by holding onto vested RSU shares.
What’s It Worth to You?
The second misleading reason people hold vested RSUs is the natural human tendency to overvalue things already in our possession – a behavioral bias called the endowment effect. Would you use all of your $25,000 cash bonus to buy your employer’s stock? If the answer is no, then you are likely exhibiting the endowment effect and should promptly sell and diversify your RSUs as they vest.
Back to the Big Picture: Your RSUs as a Piece of Your Financial Plan
So, when should you hold or sell your vested RSUs? Rather than be swayed by bogus tax or biased behavioral logic, the actual answer depends on (1) your overall portfolio, and (2) your long-term financial goals.
Think of RSUs as a Piece in Your Entire Portfolio
RSUs should be one part of a larger portfolio strategy. If your goal is to have a completely diversified portfolio, you should sell vested shares immediately and reinvest the proceeds in a diversified portfolio.
If you want to accumulate more of your company stock by holding vested shares, it’s best to limit this holding to no more than 10% of your overall net worth. That’s because a concentrated position in any one stock poses an unnecessary investment risk. Most companies underperform the market as a whole. Even worse, 40% of all stocks suffer a permanent decline from their peak value of 70% or more.
It’s common to see investors build a concentrated position in their employer’s stock because of their emotional investment in the company. After all, you’re probably relatively informed about your employer’s operations, and hopefully you feel confident about its future. Unfortunately, familiarity does not mean you have superior information about what the future holds. In fact, familiarity often causes employees to overweight the positives and downplay the risks.
It’s helpful to remember that a considerable amount of your human capital is also tied to your company, so your total company-specific risk goes beyond just the stocks. Revisit your RSU strategy if you are accumulating vested RSUs while already having a concentration of your wealth tied to your company’s future. You might be succumbing to the endowment effect.
Think of RSUs in Terms of Your Financial Goals
Because RSUs typically vest in large chunks you have to wait for, it is natural to think of them as a forced savings plan for a big future goal.
But once the shares vest, pay close attention to when you will need to use them. It is risky to hold a large sum of money you need soon in a volatile investment like a single stock. If the stock price falls, it puts your goal in jeopardy.
So, if you’re accumulating assets you plan to spend in, say, the next year or two, your RSUs may not be the right tool for the job. As an aggressive and risky investment, RSUs are misaligned with dependably paying for short-term goals. On the other hand, it may be more appropriate to allocate a small part of your portfolio to your company stock for long-term goals like retirement or general wealth accumulation. (Even then, we suggest ensuring the allocation fits into your globally diversified equity portfolio.)
Picture the Benefits of Company Stock Ownership
Owning a vested stake in your career through RSUs can be a great win for both you and your employer. You can further maximize this benefit by building a tax-wise plan based on your overall financial goals and broader investment portfolio. Managing your vested shares in the context of your greater goals gives you the best odds for ensuring all the pieces in your life’s puzzle fall into place as planned.
Disclaimer: This material has been prepared for informational purposes only and should not be used as investment, tax, legal or accounting advice. All investing involves risk. Past performance is no guarantee of future results. Diversification does not ensure a profit or guarantee against a loss. You should consult your own tax, legal and accounting advisors.