Restricted Stock come in two different forms: Restricted Stock and Restricted Stock Units. This page explains the key basic concepts of RSUs. An RSU is an unfunded promise by your company to give you stock, should you meet the restrictions the stock has. This page won’t go every detail or strategy surrounding RSUs. This is just for the basics. Let’s run through a fictional scenario to highlight the key areas to understand:
Barry is awarded 100 RSUs on Jan 1, 2021. If the company’s current fair market value (FMV) of the stock is trading at $50, Barry would realize a $5,000 total gross profit. This is how an RSU works in its most basic form. Here are the details Barry will need to work through:
Grant: Jan 1, 2021 is Barry’s grant date. This is the date he was granted his RSUs. Upon grant, your company will have you sign a grant agreement specifying all the details of the award to you. At this point, it would be wise to read carefully through the agreement and to save a copy for your own records. This is NOT a taxable event.
Restrictions: After you are granted awards, your RSU is generally considered restricted until it meets the vesting requirements. Restricted basically means you don’t own the stock yet. You must first meet some requirements to life the restriction. The most common restriction is time based on continued employment.
Vesting: Companies will attach a vesting schedule to the awards to retain talent over periods of time. Your RSUs are essentially restricted from exercising until the option vests. For example, Barry’s RSUs will vest accordingly:
-25% of the awards on the Jan 1, 2022
-75% over the remaining 15 calendar months
This means Barry will have 25 RSUs vest (25% of 100) on January 1, 2022. 5 RSUs will vest on Feb 1, 2022, 5 more on March 1, 2022, etc. This will continue until all the RSUs vest or the RSUs expire.
Expiration: Unfortunately, your RSUs can lapse and become worthless under several circumstances. If you quit your job, die, or become disabled, your RSUs can accelerate and all vest at once or they can expire worthless. Your grant agreement will stipulate the details of what happens under certain life events.
Vest: On Jan 1, 2022, 25 of Barry’s RSUs will vest. This is a taxable event and Barry will be responsible for paying ordinary income tax on the full FMV of his vested shares. If the FMV is $100 at vest, Barry will have an additional $2,500 (25 shares vesting x $100 FMV at vest) of ordinary income subject to federal, state and local, and FICA taxes that will be subject to withholding.
FICA taxes consist of Social Security and Medicare. Social Security is taxed at 6.2% against all ordinary income (RSUs in this case) up to $142,800 for 2021. Medicare has no cap and is taxed at 1.45% against all ordinary income. There is also a 0.9% additional Medicare tax for higher income earners. Be aware that you might have already maxed out your Social Security depending on when the RSUs vest and how much ordinary income you had throughout the year.
Federal income taxes also require withholding at supplemental rates. The supplemental rate is 22% but increases to 37% if your supplemental income is above $1 million for the year.
Back to our example, let’s say Barry is required to withhold $500 for taxes of his total vested amount of $2,500. Barry has a few options as to how he can account for the withholding:
- One option is to pay in cash.
- Another option is to deduct the amount due from your paycheck, assuming your paycheck is big enough.
- Another option is to ‘sell to cover’. This popular approach allows you to sell some of your shares that just vested and use the proceeds to pay for the withholding. In the case of Barry, he would sell 5 ($500 withholding / $100 fair value per share ) of his 25 total vested shares, leaving him with a net of 20 shares.
- You also have the option of completely liquidating the entire vested amount and having the net cash sent to you.
Please note that not every company allows all payment options for withholding. Some companies will only allow ‘sell to cover’ to pay for withholding. If vesting happens during a blackout period of which you’re not allowed to sell, you could be left in a tough spot by holding onto a large amount of company stock. Trying to manage a large, concentrated position of company shares is another discussion all together. It’s critical that you contact your company at grant/award to inquire about withholding options. Some companies will send you a form a few weeks or a month before vesting. Other companies will want to know right after grant/award.
Continuing with our previous example, let’s say Barry is ready to sell his vested shares. Barry elected to sell shares to cover his withholding when the RSUs vested, so he will have a net of 20 shares remaining he is eligible to sell. If Barry sells his shares for $150/share he will net ($150 FMV at sell x 20 vested shares) $3,000. Since Barry paid ordinary income taxes on the value of his vested shares ($2,000 net after the ‘sell to cover’ election), he will only have to owe tax on the gain over that amount: $1,000 in this case subject to capital gains tax.
Withholding Enough? It’s important to remember your withholding might not actually reflect the tax amount due when you’re ready to file. The supplemental withholding rate is 22%. In 2021, the 22% marginal federal income tax rate for single filers ends at $86,375. For married filers, the 22% marginal bracket ends at $172,750. If you’re in a high-income area such as the San Francisco bay area or New York, you could easily be in a much higher tax bracket.
The IRS has a ‘pay-as-you-go’ system. If you aren’t withholding enough in tax at the end of the year to satisfy your safe harbor, you’ll be subject to penalties. Tax planning to ensure you’re not under withholding is crucial and could prevent a larger than expected tax bill come next April 15th.
How do you prepare and ensure you’re withholding enough? You have a few options:
- Adjust your W4 to withhold extra federal taxes. The IRS allows you to withhold additional amounts on the recently revised W4. You can increase your withholding amount to account for additional tax owed beyond the supplemental rate. This on done on line 4c of the revised 2021 W4.
- Make estimated tax payments: You are eligible to make quarterly tax payments to the IRS to keep up with your tax liability throughout the year. IRS form 1040-ES provides details.
- Ensure you’re meeting your safe harbor: The IRS has a safe harbor amount you need to withhold throughout the year. The amount required will depend on a few factors, but generally it is 90% of the current year or 100% of last years, whichever is smaller.
Final Words: RSUs are simply a cash bonus in the form of stock. If you choose to not sell your RSUs at vesting, you’re making the decision to invest your cash bonus back into the company you’re working for. This can potentially be a risky move. A great question I like to ask my clients is: Out of all the companies in the world you can invest in, would you choose yours? This requires some real honesty when answering due to the conflicts to that answer. There isn’t a right or wrong answer to that question but does put into perspective the risk with not selling completely at vesting.
What if things go south at your company: you get laid off and the stock tanks simultaneously. This is a very real possibility. Nobody likes to think THEIR company will turn sour, but the reality is that things happen that are out of your control all the time. You’re then left with vested shares that are valued far below their vested amount (that you paid ordinary tax on) and you’re now laid off. A double bad day.
Remember that what’s best for someone else, might not be best for you.