With the constantly changing job market we have today, companies use different ways to attract and retain employees. One of them is using Restricted Stock Units (RSUs) as a form of equity compensation, providing employees with a valuable stake in their organization's success.
In this article, we will provide you with a comprehensive discussion about RSUs and their tax implications for employees.
What Is a Restricted Stock Unit (RSU)?
A restricted stock unit (RSU) is equity compensation that companies issue to employees. It is a pledge wherein a company promises to give its employees shares of stock or cash equivalents once certain conditions are met.
The grant is “restricted” because it is subject to vesting, which is typically based on performance goals or length of stay in the company.
Unlike stock options, RSUs always have some value to you, even when the stock price drops below the price on the grant date.
For example, your company grants you 3,000 RSUs when the stock market value is $20. By the time the grant vests, the stock price will have fallen to $15. The grant is then worth $45,000 to you before taxes.
How RSUs Work?
RSUs are unfunded promises until vested. Once the milestone or the required length of stay is met, a value is assigned to it that is equivalent to the fair market value of the shares upon satisfaction of the vesting schedule. Equivalent value in cash can be opted for as well.
Its limitation revolves not only around it but also around the transfer or sale of the shares received once granted.
Holders of RSUs have no voting rights and do not receive any dividends. After the vesting date, once shares are received, only then can they exercise voting and dividend rights.
Companies may, and do, provide dividend equivalent distributions for RSUs that have not vested yet.
If an employee is terminated, vesting typically comes to an end. It may continue in the event of an employee's death, disability, or retirement. The actual plan and grant agreement stipulated upon employment govern cases like this.
Advantages and Disadvantages of RSUs
By being a negotiable and low-risk investment opportunity, RSUs impose many advantages, which include the following:
Ease of Comprehension: Employees frequently favor RSUs for their simplicity in nature, as restricted stock unit arrangements can be easily understood in contrast to alternative equity compensation schemes. It is clear to monitor the vested shares and their corresponding monetary worth.
Flexibility: RSUs provide employees with a level of freedom that may not be available in other compensation methods. Even if employees change jobs, they can retain their vested RSUs without having to forfeit them, thus safeguarding the stability of their investment portfolios.
Furthermore, employees have the option to convert their vested RSUs into cash, allowing them to finance various personal ventures such as education expenses, retirement plans, housing loans, and more.
Zero Investment: Employees are not required to pay an upfront fee to acquire company shares.
This lack of payment eliminates the risk to their financial portfolios and offers long-term advantages. Furthermore, RSUs will consistently maintain value unless the share price plummets to zero, an unlikely scenario. Therefore, employees can be confident in possessing a valuable financial asset.
Minimal Admin Cost: Employers benefit from minimal administrative costs associated with RSUs since there is no need to track and record actual shares. Furthermore, RSUs enable companies to postpone issuing shares until the vesting schedule is fulfilled, effectively delaying the dilution of their existing shares.
Alignment with company performance: RSUs align the interests of employees with the overall performance and success of the company. When employees hold RSUs, they have a direct stake in the company's growth and profitability.
Although restricted stock units are often considered a favorable form of equity compensation, they do have certain drawbacks for employees, which include:
Lack of Dividends: Until vested, restricted stocks lack inherent value, so dividends are not disbursed on these allocated shares to employees.
Nevertheless, certain companies offer the possibility of depositing dividend equivalents into an escrow account, serving as a means to counterbalance tax obligations. The inclusion of this provision is subject to negotiation between employees and their employers.
No voting rights: Sadly, restricted stock units do not grant voting privileges. Consequently, employees have no influence over significant corporate policy amendments until the shares are vested.
Lack of immediate liquidity: Employees cannot access the fund value of their RSUs or convert it into cash until the RSUs vest. It is a disadvantage, especially if the employees need immediate funds for personal or financial needs.
Tax implications: At the time of vesting, RSUs are subject to taxation even if the employees choose not to sell the shares. This may impact their overall financial planning due to the tax liability that needs to be managed.
Potential forfeiture of shares: If the employees choose to terminate their employment before the vesting date, there is a possibility of forfeiting any unvested shares.
For example, an employee is promised 3,000 shares spread over 3 years. If the employee decides to leave after 2 years, the 1,000 unvested shares cannot be claimed.
How to manage your RSUs
Managing RSUs can be a complex matter, despite the fact that the concept of RSUs is straightforward.
With that, let’s dig a bit further into how to properly manage RSUs.
Accept your RSU grant
Review the terms and conditions of the grant carefully. If you agree with the terms, accept the grant as per the instructions provided by your employer or the stock plan administrator.
Plan for taxes
RSUs are subject to taxation, typically at the time of vesting. The vested RSUs’ worth is taxable income, and you will need to pay taxes on that amount.
Referring to a tax professional to understand the specific tax implications can help you estimate the tax liability and explore potential strategies to minimize your tax obligations.
Consider your investment goals
RSUs represent an ownership stake in your company. Evaluate your investment goals and risk tolerance to determine whether holding the shares aligns with your financial objectives.
Some individuals prefer to sell the RSUs immediately upon vesting to diversify their portfolio, while others may choose to hold onto the shares for potential long-term gains. Understanding your financial situation and goals can help inform your decision.
Keep track of key dates
Stay organized by noting important dates related to your RSU grant. This includes the vesting schedule, which outlines when your RSUs become available for you to exercise or sell. Additionally, be aware of any expiration dates or deadlines associated with your RSU grant.
Consult with a financial advisor
Seeking guidance from a financial advisor can be beneficial when navigating the complexities of RSUs. They can provide personalized advice based on your financial goals, tax situation, and overall investment strategy.
A financial advisor can help you understand the implications of selling RSUs, strategize around tax efficiency, and explore other investment opportunities.
Decide when to sell your shares
If you choose to sell your RSU shares, you will need to determine the optimal timing. Factors such as market conditions, your personal financial needs, and any potential insider trading restrictions may influence your decision. Consider consulting with a financial advisor or a stock plan administrator to help you assess the best time to sell.
Remember, the information provided here is general in nature and not a personalized financial advice. It's important to consult with professionals who can take into account your specific circumstances before making any decisions related to your RSUs.
If you’re looking for an expert you can rely on to help you manage your RSUs, Compass CPA, PC is here to help!
How are RSUs taxed?
When RSUs vest, meaning they become available for you to receive or sell, they are generally subject to taxation. The fair market value of the RSUs on the vesting date is the basis for income tax computation.
The value of the vested RSUs is considered ordinary income. You need to include it in your annual tax return for reporting purposes.
Tax withholding on your RSU income
A portion of the vested RSUs is often withheld by employees to cover the income tax liability.
Shares being withheld are either sold to pay the taxes or simply retained.
In some cases, additional taxes may apply. For example, if you decide to hold onto the vested RSU shares and sell them at a later date, any subsequent gain or loss is treated as a capital gain or loss, and capital gains tax will apply.
RSUs are subject to Medicare (FICA) and Social Security taxes at the time of vesting, together with federal and state income taxes.
Understanding RSU tax rates
RSUs are generally considered supplemental income, and most companies apply a flat rate of 22% for federal income tax withholding. The tax rate increases to 37% if the value exceeds $1 million.
This calculation doesn't include state income tax, Social Security, or Medicare tax withholding. When combining the states’ taxes withholdings can be a good bit higher. For instance, someone who is living in California could withhold up to 40% in combined IRS and state taxes.
To avoid facing significant tax charges or penalties later on, it's crucial to have a clear understanding of the amount withheld on future RSUs.
If the recipient of RSUs suspects that the withholding amount is significantly lower than expected, it would be advisable to adjust their W-4 form or make quarterly estimated tax payments.
It's recommended that RSU tax recipients seek guidance from a tax specialist if they are uncertain about their tax situation.
RSUs VS Stock options
While there are certainly some similarities, RSUs and stock options are two entirely different things.
Stock options and RSUs are both methods used by companies to provide additional compensation, either through stock or the opportunity to buy stock at a discounted price.
The primary distinction between stock options and RSUs lies in what you receive. With stock options, you have the option to purchase stock at a specific price before a designated date, but the decision to actually buy the company stock is entirely voluntary.
On the other hand, RSUs grant you the stock itself once the vesting period is completed, without the need to make a purchase.
RSUs VS RSAs
A Restricted Stock Award (RSA) is a restricted stock you receive as part of your compensation once you become a shareholder in a company. This award grants you immediate ownership of stock and the associated voting rights.
RSAs are typically granted on the date of employment, but certain restrictions, such as a vesting schedule, still apply.
While both RSA (restricted stock award) and RSU (restricted stock unit) are types of restricted stocks, there are several significant differences between them. First, an RSA grants the employee the right to purchase shares at their fair market value (FMV), at a discounted price, or at no cost at all.
In contrast, an RSU is a grant that is valued in terms of company stock, but the actual shares are not received until the restrictions or vesting conditions are met. Once requirements are fulfilled, shares are given to the employees either as stock or cash, as planned.
Furthermore, there are significant distinctions between RSA and RSU in terms of tax compliance and legal aspects, as listed below:
Tax Timing: Since RSAs include the acquisition of shares, they are taxed as of the grant date. RSUs, on the other hand, are not purchased; therefore, taxation is postponed until the conclusion of the vesting schedule, at which point shares are granted.
Vesting Conditions: RSUs frequently include a number of vesting requirements that must be satisfied before the employee is able to acquire the shares, whereas RSA vesting is frequently based on a time-based schedule.
83(b) Election: RSUs are taxed when they vest and are not eligible for the 83(b) election. However, RSAs might be eligible for an 83(b) election, which could offer tax benefits.
Treatment of Unvested Shares: Unvested shares in RSUs are promptly forfeited back to the firm upon termination. In contrast, following termination, the corporation frequently repurchases unvested RSA shares.
Timing of Share Release: RSU shares have the option of deferring their release until a later time, whereas RSA shares do not. Additionally, the payment of other taxes may be postponed until distribution or the time the employee receives the shares or cash equivalent, depending on the company's plan regulations. The employee may be compelled to pay the minimum taxes as defined by the employer upon vesting RSUs.
6 Strategies to Lower Your 2023 Taxes on RSUs
Minimizing tax liability on Restricted Stock Units (RSUs) can be a smart financial move. Here are six strategies you can consider to lower your 2023 taxes on RSUs:
Maximizing Tax-Deferred Contributions through RSUs
One strategy to lower your taxes on RSUs is to maximize tax-deferred contributions. Consider contributing the maximum amount allowed if your employer offers a 401(k) or similar retirement plan. With that, your taxable income decreases, which in turn lowers the tax you need to pay.
Deduction Bunching to Decrease RSU Taxes
Deduction bunching is a strategy where you bunch your itemized deductions into a single year to exceed the standard deduction threshold. By doing so, you can potentially lower your taxable income for that specific year and reduce the taxes owed on your RSUs.
This strategy can be particularly useful if you have control over the timing of deductible expenses, such as charitable contributions or medical expenses.
Utilizing Donor Advised Funds (DAFs) for Tax Efficiency with RSUs
Donor Advised Funds (DAFs) are charitable giving vehicles that offer immediate tax benefits while allowing you to distribute donations over time. By contributing RSUs to a DAF, you can receive an immediate tax deduction based on the fair market value of the donated RSUs, effectively reducing your taxable income for the year. Additionally, the RSUs can be sold within the DAF without incurring capital gains taxes.
Hedging with Options to Defer RSU Taxes
Another strategy is to hedge your RSU holdings using options. By purchasing put options on the company's stock, you can protect against potential downside risk while deferring the taxes owed on your RSUs.
The value of the put options increases as the stock price declines, creating an offsetting effect. This strategy allows you to delay selling the RSUs until a more tax-advantageous time.
Sell RSUs in a Tax-Efficient Manner
When it comes time to sell your RSUs, consider the tax implications of different selling strategies. For example, you may qualify for long-term capital gains tax rates if you hold your RSUs for at least one year, which are typically lower than ordinary income tax rates. By selling RSUs strategically and taking advantage of long-term capital gains rates, you can minimize your tax liability.
Take Advantage of Losses
You can use your investments that have incurred losses to offset the gains from selling your RSUs. This strategy is known as tax loss harvesting. By strategically selling investments that have declined in value, you can offset the taxable gains from your RSUs, reducing your overall tax liability.
Reporting RSUs on Tax Returns
Similar to any other type of income, the IRS expects to receive a fair portion of your earnings. RSUs are subject to taxation as well. When you receive an RSU plan, known as a grant, there is no immediate taxable event. You are not required to pay taxes on the RSUs until you gain control of them in the form of company shares.
The IRS imposes taxes when the compensation becomes recognized, meaning it can no longer be retracted by the company. Once the RSU shares vest, indicating that they are now legally yours and cannot be taken back by the company, you are obligated to pay ordinary income taxes based on the fair market value of the shares at the time of vesting.
IRS forms and instructions
RSUs, or Restricted Stock Units, are typically included in the taxpayer's W-2 form under the "Other" category (Box 14) as a form of income. To report this income on their federal and state tax returns, taxpayers can simply transfer the amount stated in Box 14. Upon examining the W-2, employees may discover that their employer did not withhold enough funds to cover the taxes owed. In such cases, employees will need to make adjustments to their tax payments accordingly.
Once the RSU stocks have vested, if the taxpayer decides to sell them, they must determine the basis of the stocks. To calculate any gain or loss from the sale, they subtract the selling price from the stock's basis. This information is then reported on Schedule D and Form 8949 of their federal tax return.
Tax implications of incorrect reporting
The IRS and local authorities may impose penalties and fines for inaccurate or late reporting. If an IRS audit reveals that the employees underpaid their taxes because of false financial reports, they will also be penalized with interest.
Q: When do RSUs vest?
A: RSUs typically vest over a set period of time, such as four years. Vesting may also be based on performance goals or other metrics set by the company.
Q: What happens if I leave the company before my RSUs vest?
A: If you leave the company before your RSUs vest, you typically forfeit any unvested units. However, some companies have a "cliff vesting" period where a certain percentage of RSUs vest after a set amount of time, such as one year.
Q: Can I sell my RSUs?
A: Once RSUs vest, you can sell the shares or hold onto them. If you sell the shares, any gains are subject to capital gains tax.
Q: How do I know the value of my RSUs?
A: The value of RSUs is based on the fair market value of the company's stock at the time of vesting. This value can fluctuate over time based on market conditions and the performance of the company.
Q: What should I do with my RSUs?
A: Whether to sell or hold onto your RSUs depends on your investment goals and risk tolerance. It's important to consider the tax implications and diversification of your portfolio when making this decision.
Q: Can I receive dividends on my RSUs?
A: Some companies offer dividend equivalents on RSUs, which are paid out in cash or additional shares of stock.
Q: What happens if the company's stock price decreases?
A: If the company's stock price decreases, the value of your RSUs will also decrease. However, you may still owe taxes on the original fair market value at the time of vesting.
Q: Should I consult with a financial advisor about my RSUs?
A: It's a good idea to consult with a financial advisor or tax professional to understand the tax implications and develop a plan for managing your RSUs.
RSUs provide an incentive for employees to stay with a company for the long term and help it perform well so that their shares increase in value.
Managing RSUs requires careful planning, an understanding of tax implications, and potentially seeking advice to make informed decisions based on individual financial goals and circumstances.
With the professional insight of Compass CPA. PC, we can help advise you on the best way to manage your RSUs, including a tax-efficient strategy for your RSUs.
Feel free to schedule a free discovery call to see how our financial planners can help you today.