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[et_pb_column type=”4_4″][et_pb_text admin_label=”Text”]If you work at a tech company, your compensation likely stretches beyond the numbers on your paycheck — and that’s a good thing.
While a strong income is essential to growing wealth, getting access to some kind of ownership in the company through stock options or other incentives can help tech employees grow significant nest eggs in a short period of time.
Providing equity to employees is a common practice, and offering restricted stock units, or RSUs as part of compensation packages is growing in popularity amongst startups and large firms alike.
Companies often start by offering stock options when the business is young, but may switch to restricted stock units in later stages. In addition to the RSUs themselves, we sometimes see options for RSU exchanges. We find this is more common in companies that raise down rounds and then have underwater stock options.
No matter what your company chooses to offer you as part of your compensation package, you need to know what to do with RSUs should you receive them. This guide to restricted stock units will tell you everything you need to know to make smart decisions with confidence.
What to Know If You Receive Restricted Stock Units
RSUs aren’t actually options; they’re grants made to employees. Employers can make restricted stock unit grants as a way of providing shares to employees. Receiving the grant is not the same thing as receiving shares.
In order to receive shares, you have to let the RSUs vest first.
When you receive your RSUs, that’s the grant date. The dollar amount of the RSUs is divided by the fair market value of the company’s shares to determine how many shares you can receive.
Then, your RSUs will vest based on a schedule determined by your company, either with a single vest or double vest. This vesting schedule is what makes restricted stock options, well, “restricted.”
A single vest is time-based. A typical structure is a four-year period with a one-year “cliff.” This means that 25% of your RSUs vest after the first year (or cliff), then the remaining 75% will vest over three more years.
A double vest is both event and time-based. This method of vesting runs on a set schedule that determines your total vested shares when a specific event occurs. That event could be an initial public offering (IPO) or change in company ownership through an acquisition.
What Happens When Your RSUs Vest
At vesting (which is, again, triggered by either a specific schedule or an event), two things will happen:
- The company will withhold taxes
- You’ll receive the shares from your restricted stock units
Here’s what you need to know to prepare for the consequences of each.
Tax Withholding on RSU Vesting
When a number of your shares vest, your company will sell some of the shares and hold some amount of the cash generated from that event for taxes. In theory, that’s useful (just like it’s helpful that your company withholds taxes for you on your paycheck).
But the problem is, your company is unlikely to withhold enough — which could leave you in a bad position come tax-time if you’re not prepared.
Here’s what usually happens:
Your salary and bonus are paid through payroll, and that compensation follows the IRS withholding tables. The higher the dollar amount of any one paycheck, the greater the dollar amount of your tax withholdings.
In other words, with withholdings done through payroll, withholdings go up when your pay goes up. If your paycheck goes down, withholdings go down.
But RSUs are handled through your equity awards account, not payroll. Your employer will withhold cash for taxes at a flat rate, which is usually 25% for federal income taxes and 10% for state taxes.
This doesn’t’ scale like payroll withholdings, which is where you can run into a problem.
Let’s say you have $1 million dollars worth of RSUs. Vesting is triggered by IPO, leaving you with $1 million dollars of W2 income.
The company should withhold 37% for federal taxes, or $370,000. But based on what we just explained above, your actual withholding would be 25%, or $250,000.
That leaves you with a potential gap of $120,000, and that’s not even considering what you’d owe for state taxes. That’s a massive tax bill, and you don’t want to be surprised by it — so you can’t rely on your company alone to withhold the proper amount of cash to pay taxes on your behalf.
When You Receive Shares
Whatever amount of shares the company doesn’t sell to cover withholding for taxes will pass onto you — and what you do with your shares is up to you.
You can sell them in your trading window, or you can hold them.
You might want to talk to a financial planner with expertise into this kind of situation to create a specific strategy that you can use if you’re not sure which option is best for you. But in general, we recommend selling RSUs ASAP.
We’ll explain why in a moment, but first, let’s look at some recent trends to give you a little more context.
The Trends We’ve Seen with Restricted Stock Units
Here are a few of the things we’ve seen tech companies do for employee stock options and RSUs.
With Facebook RSUs, there’s no delay in vesting. New grants vest immediately — and this might be a tactic to help recruit new employees and improve retention of existing employees.
We expect other large tech firms to follow in Facebook’s lead here, and reconsider or change how they handle RSUs and vesting schedules.
Google often adjusts RSU vesting and grants as part of the salary negotiation process for employees. (We frequently help clients negotiate compensation, and the number-one rule is to always ask for more.)
From experience, we know Google doesn’t like to give more salary and bonuses. But they will offer more Google stock units (GSUs) or an accelerated vesting schedule to make their compensation offer more attractive.
Even if you don’t work for Google, though, this is an excellent lesson to learn. Know that you can always try to use RSUs in negotiation — and that you should always ask for more, or at least a more favorable vesting schedule.
Uber
Uber switched to RSUs in the last few years, and this year new grants are expressed as a total dollar amount with a grant date (just like Facebook or Google). We believe this is also an indication of Uber’s intent to go public soon.
Thinking About RSUs in Context of the 83(i) Election
The 83(i) election, which was included in the Tax Cuts and Jobs Act of 2017, offers a nice tax break for RSU holders.
The provision allows you to elect to defer taxes for up to five years. That can provide you with a lot of time to save and prepare for your tax bill. It also gives you the choice to defer taxes until an exit, such as an IPO, and then have a greater portion of tax bill be counted as long-term capital gains.
You can also choose to revoke your election and pay the taxes owed at any time during the five years.
When It Comes to RSUs, Sell ASAP
Once your RSUs vet, you should sell them as soon as you can. Remember, these are taxed at vesting, so you’re on the hook for a big tax bill either way.
And no, it doesn’t really matter if you deeply believe in the company’s stock!
For starters, “believe” or “think” are not quantifiable. The only way you should invest in your company’s stock by holding your RSUs is if you have the cash on hand to pay taxes and you believe that the stock will outperform the total US stock market, and that’s a tall order.
The total US stock market is:
- Diversified, consisting of about 5,000 companies
- Predictable, with historical records going back to 1927
- Easy to invest in, thanks to the abundance of ETFs and mutual funds
On the flip side, your company is:
- Not diversified (it’s a single company)
- Unpredictable, since there’s no reliable historical record
Yes, your upside is potentially unlimited… but the fact that your company’s stock is neither diversified nor predictable means that your downside is only limited by bankruptcy. In that situation, your stock would end up worthless. It’s a crapshoot.
But let’s say you still believe in your company. Here’s what to do:
- Buy the stock now
- Don’t wait for it to vest
- Buy shares now with the cash you have in the bank
- Then sell the RSU shares as they vest
Why? Because if the price of the stock goes up faster than the US stock market, buying now gives you the opportunity to convert all of that future appreciation to long-term capital gains tax treatment. With your RSUs, all appreciation between grant and vest will be taxed as ordinary income.
Most clients who use this thought experiment don’t want to give up cash in hand to buy shares now. So we sell all RSU as soon as possible after they vest.
What Happens If You Don’t Sell Your RSUs
There are no tax advantages to holding RSU shares. Sometimes people get confused here and think, “If I hold for a year, then I pay long-term capital gains.”
Yes and no. RSUs are not incentive stock options (ISOs), which allow you to exercise, pay no taxes, and then have all your gain taxed as long-term capital gains.
With RSUs, 100% of your income gets taxed as ordinary income when they vest.
If you hold after vest, there are only two possibilities:
- The price goes up: After one year, you can sell and pay long-term capital gains on the price increase from vest to sell.
- The price goes down: You can sell and harvest your loss, but you only get to use that loss to reduce capital gains or deduct $3,000 from other income.
This is a terrible tax position to be in. You paid ordinary income taxes at vest, but you can only deduct losses up to $3,000 per year.
The Most Common Mistake We See People Make with RSUs
The worst but also most common mistake we see when it comes to RSUs? Doing nothing.
Most people are unsure of what to do, or they don’t have time to research and decide. So they do nothing. But as RSU shares accumulate year after year, sometimes from multiple employers, doing nothing gets exponentially more costly as the years go on.
This is where a financial advisor can help. A good advisor can give you not only clarity and confidence but also the tools you need to take action.
They don’t expect you to know everything about RSUs; that’s their job, and they have the expertise required to avoid costly mistakes along the way.
If you’ve received RSU grants, it’s crucial to create a plan as soon as possible for how you’re going to deal with them when they vest.
Considering that some companies, like Facebook, are now offering RSUs with immediate vesting, it may even be wise to speak with your financial advisor before taking a job with a large tech company.
Having a strategy planned out will not only help you know what to do, but it can help you avoid costly mistakes and put you in a position to start building wealth sooner.
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