With the competition for quality employees growing, many companies have turned to equity compensation as a way to attract and retain talent. Currently, the most common form of equity compensation is restricted stock units (RSUs). And while RSUs may seem straightforward, they are also frequently misunderstood, especially by employees who have previously dealt with options and who therefore may not completely grasp how the two vehicles differ.
What are RSUs? How do They Work?
RSUs are an outright grant of company stock that is given as compensation, either to augment a base salary or as a bonus. Unlike stock options, which must be “exercised” (purchased), RSUs are owned outright by the recipients once they vest. After RSUs vest, which can be immediate or based on a pre-defined schedule, employees are free to do what they want with them, including hold, sell, or gift them.
Understanding the Tax Implications
From a tax perspective, RSUs are treated just like cash compensation, and are similarly subject to earned income tax rates. So regardless of what you ultimately want to do with your RSUs, the granting company must sell enough of the stock to be able to withhold federal taxes (at a 22% rate) when the RSUs vest. Unfortunately, this is a much lower marginal tax rate than what may ultimately be due for a particular recipient. As a result, unless you are keeping track of the tax liability, you could end up with a very sizeable tax bill – and perhaps a penalty as well – come tax time.
In order to avoid such a nasty tax surprise, it is always prudent to sell enough additional shares to cover the full income tax liability that will be due when your RSUs vest. Typically, your tax preparer or financial advisor can help you estimate that additional tax liability.
But what should you do with your remaining RSUs?
Hold, Sell, or Gift?
If you decide to hold on to your RSUs, you are essentially deciding to take a cash payout from your company and invest in your company’s stock. The fact that this is the “do nothing” option makes it easy to choose, which of course is what the issuing company wants. You might indeed opt to do that if you work for a company with excellent growth prospects. Typically, however, employees are already in a position to continue to benefit from the success of their current employer via options or additional RSUs. So however optimistic you may feel about your company’s future, it is usually much wiser to accept the additional compensation in cash and take the opportunity to diversify your investment risk. Owning too much of your company’s stock can literally be too much of a good thing, resulting in what is referred to as ‘concentration risk’.
An extreme, though famous, example of concentration risk was the Enron collapse of 1999. At the time, Enron was a much touted energy company, and was growing by leaps and bounds. Many employees, eager to ride the Enron wave of surging share prices, kept their pension money fully invested in the company’s stock. Unfortunately for them, a series of accounting scandals caused the company to collapse, and in the ensuring bankruptcy Enron stock became worthless. The employees who had bet their entire retirement on the company lost everything. Admittedly, this is an extreme example. But the principle is important. You are almost always better off investing in a diversified portfolio of stocks if you want to maximize your long-term potential while minimizing your downside risk.
But what about the gifting option? Again, think of RSUs just as you would think about cash. True, you could gift them and take a tax deduction if the total gift qualified. But there are usually more tax efficient ways to get a charitable deduction than donating cash. The most effective of these is to gift an asset (stock) that is already highly appreciated because you’ll be able to count the full value of the asset – and not just your cost – as the charitable donation.
The bottom line? If you expect to continue to receive RSUs, the best course of action is to develop a financial plan that accounts appropriately for this source of supplemental income. Aligning your income sources with your goals and timelines will bring clarity to any decisions you might be considering regarding your RSUs.
Image by mavo from Shutterstock
