Have you been incentivized with equity-based compensation in the form of restricted stock units (RSUS)? Here are five things to know in making the most of your RSUs.
What You Need to Know and Consider About RSUs to Maximize their Benefit.
Equity-based compensation provided to employees can come in many forms. Companies have long used stock options to incentive performance and retain employees. Beginning in 2005 though, accounting standards required that employers treat stock options as an expense. This change resulted in the growing usage of restricted stock units. While RSUs offer some compelling advantages, they can also be complex, warranting careful planning, and consideration to maximize benefit.
#1 The Basics: What Are RSUs?
Restricted stock units (RSUs) are increasingly in use by both private and public companies to provide equity-based compensation to valued employees. Grants of RSUs provide an employee with a certain number of shares that vest according to a schedule or the achievement of certain company milestones. Once RSUs vest, they are no longer under restriction and the employee takes ownership of the shares. These shares are no different from the outstanding stock owned and traded by other shareholders.
In a competitive job market, companies can use RSUs to recruit and retain talented employees. They can be very advantageous to recipients if the company performs well, and its share price grows in value. Employers benefit because of the built-in incentive for employees to stay and align efforts with corporate objectives. It can be a great win-win.
#2 The Vesting Schedule: When Do Your Restrict Stock Units Become Worth Something?
Companies grant RSUs with certain restrictions that can require an employee to stay with the company for a certain period of time (vesting schedule), meet specific performance objectives, or both. An individual does not take ownership of these restricted shares until they meet vesting conditions. Until then, your grant has no value as it is nothing more than an unfunded promise to issue shares at some point in the future.
Restricted stock units that vest solely according to time-based requirements are considered single-trigger RSUs. Those that have both time-based and performance or event-related conditions are known as double-trigger RSUs.
Single-trigger (time-based) RSUs
An employee is granted 10,000 RSUs, 20 percent of which vest after one year of service and then semi-annually in equal installments for the following four years. In this example, the grantee would take ownership of 2,000 shares at the end of year one and then 1,000 shares every six months from that point forward. At the end of five years of service, the worker will be the proud owner of 10,000 shares of their employer’s company stock (assuming, of course, that they hold on to all shares).
This example is considered a graded vesting schedule and is very common for most RSU grants. However, employers could also use a vesting schedule in which all granted stock units vests at the same time, for example, after three years. People know this as cliff vesting.
Double-trigger (time & performance based) RSUs
Double-trigger RSUs have additional criteria that need to be met before the removal of restrictions. Consider the time vesting requirement in the example above. If in addition to this vesting period, a company needed to meet a specific milestone – like the launch of a new product or a liquidity event (acquisition, merger, initial public offering) – then the grant would be considered a double-trigger RSU. Private companies often issue RSU grants with a double-trigger as a way for them to manage liquidity. A double-trigger also ensures employees stick around until a particular objective is met.
Whether you’ve been issued single or double-trigger RSUs, the important thing to remember is that your shares are restricted (i.e., have no value) until vesting requirements have been fully met. Once they have vested and you take ownership, it will be time to pay your tax tab to Uncle Sam.
#3 RSUs Have Tax Implications: Know and Understand These and Plan Ahead
Upon being granted restricted stock units, you will have no tax liability because you don’t own any shares until meeting vesting conditions. Once shares vest and you take ownership, a taxable event has occurred. From a tax perspective, the value of this event equals multiplying the number of shares by the per-share price and taxing as ordinary income. You can make a tax payment through company withholdings or by having your company withhold enough shares to pay taxes owed. Either way, the government gets its piece of the pie.
A second taxable event occurs when you choose to sell your vested shares. The tax consequences of this sale depend on how long you have held the stock after taking ownership (vesting). For holding periods of more than one year, you will pay a long-term capital gain of either 15% or 20%. This depends on your total taxable income. If held for less than a year, any gain will be treated as short-term capital gains and will be taxed as ordinary income.
While there’s no avoiding the income tax bill due upon vesting, some proactive planning can be beneficial before selling shares.
Important considerations include:
- Minimizing your tax burden by holding vested shares past the 1-year long-term capital gains holding period
- Working with your accountant or planner to estimate your increased tax burden from selling shares and setting asides funds to make tax payments
- Spreading out share sales in a way that moderates income taxes due over time
- Exploring opportunities to offset your expected capital gains with other investment losses
#4 Considerations for Holding onto or Selling Your Restricted Stock Units
Deciding, let alone knowing, what to do with your vested RSUs can be complex and often depends on your own unique situation. While no universal “best approach” exists, there are numerous important considerations.
Managing risk is very important for most investors and their portfolios. Diversification is key to keeping risk at tolerable levels while still achieving an acceptable level of return. Holding more than 10% of any position/stock in a portfolio can add unwanted risk and volatility to your investments. Often, it makes sense to sell a portion of your company stock and reinvest proceeds in a diversified manner.
Have you properly funded an adequate emergency reserves balance to tap in the event of income loss, temporary unemployment, or some other unforeseen circumstance? If not, selling a portion of your vested stock to fund an appropriate reserves balance might be a smart thing to do. Most of us advisors will recommend an emergency cash balance of somewhere between six to 12 months’ worth of non-discretionary expenses.
Pay Off Debt
Debt can be costly and limit financial flexibility, such as the ability to spend or save for other life goals. Using proceeds from selling company shares to pay down or pay off debt can help free up cash flow to focus on other important financial objectives.
Fund Other Financial Goals
Perhaps you desire to purchase a second home, help fund a child’s college education, save more for retirement, or fulfill charitable desires. It’s important to know that RSUs can be a good source of funds for making a down payment on a home. They can also be a good source of funds for contributing to a college savings plan or even an IRA.
Most everyday traders likely do not know as much about your company as you do. Perhaps you are optimistic about the growth potential of your company and desire to reap some benefit. Under this circumstance, it might make sense to hold a portion of your shares while balancing the need for diversification.
#5 RSUs Are Not Stock Options
Restricted stock units are uniquely different from stock options. First, RSUs do not require a purchase. Upon vesting, the shares become yours. The only costs that you will need to consider are the income taxes that will be due once vested. On the other hand, stock options require funds to purchase shares at the stated strike price. Shares are not granted to you as they are with RSUs.
Secondly, unless the stock price of your company goes to $0, RSUs will have immediate value once vested. This is not true for stock options in situations where the strike price (price at which you can purchase shares) is higher than the market price. In such a scenario, there would be no reason for you to exercise your options as you could separately purchase shares on the open market for less.
Finally, RSUs offer simplicity relative to stock options. The vesting scheduling indicates when you will receive shares and once vested, it’s very easy to determine the equity value. Options require comparison between the strike price and market price to determine their true value.
If you are fortunate with the granting of RSUs by your employer, you have many factors to consider. Did you know that RSUs can be a valuable component to your overall compensation? If managed correctly, can also help improve your financial situation.
Schedule a call with us and talk with your advisor. Discuss your best options for taking advantage of your RSUs given your unique situation.