One of the ways companies entice potential employees to join them is with the opportunity to receive additional compensation above and beyond their salary. One very common type of additional compensation given out today are Restricted Stock Units or RSU’s.
What Are Restricted Stock Units (RSU)?
RSU’s are shares of company stock that is provided to employees over a specific period of time. For example, let’s say you found a job with a great company and as part of the job offer, they give you 10,000 shares of stock. This is called a stock grant.
However, per company policy, you will only receive a quarter of that amount or 2,500 shares each year for the next 4 years. This is called the vesting period. The stock is restricted because your ownership is limited to only those shares of stock that have fully vested. If you leave the company before your shares vest, you forfeit your right to receive those remaining shares.
By giving you the shares in this manner, your company hopes that you will remain there for a long period of time. In return for your valuable service, you receive all of the stock you were promised.
You pay taxes twice with RSU’s
The first time you will pay taxes is when you receive your vested stock shares. Going back to our example, let’s say you have made it to your one-year anniversary. This means that 25% of your shares have now vested and you receive 2,500 shares. The date you receive your shares is called the exercise date. On this day the share price of your company stock is valued at $10 per share – called the exercise price, and you receive stock worth $25,000. Receiving company stock is considered income and you are responsible for paying taxes on that income.
Your company will typically withhold a standard amount for Federal and State taxes on your behalf. Sometimes this is sufficient but depending on your income level, the amount of tax withheld might not be enough especially if you are in a high tax bracket. In this situation it is not uncommon to owe more taxes at the end of the year. RSU compensation can be a major source of frustration for people if the tax impact is not planned for carefully.
The second time you are taxed is when you sell your company stock. When you decide to sell, you will be taxed on any gain you receive. This gain is the difference between the selling price and your exercise price. If you sell within one year, the gain is taxed at ordinary income tax rates. If you well after one year, the gain is taxed at the long-term capital gains tax rate.
Beware of selling for a loss
Once you receive your shares of company stock, it is treated like any other stock that you may own. You can make money but you also have the risk of losing money. That is why it is important to keep track of your cost basis (exercise price) and sell your stock before it goes below that price.
This point is critical because remember, you paid income tax on the stock that you received. Therefore, you don’t want to receive less cash than you deserve. In our example you paid taxes on $25,000 of stock that vested. Let’s say the tax you paid is $5,000 so you receive $20,000 in stock compensation. The stock unfortunately loses value and you sell it for $15,000. As a result, you paid an additional $5,000 “penalty” for holding on to the stock longer than you should have.
Beware of owning too many RSU’s
In addition to experiencing potential investment losses, the other risk for continuing to accumulate and hold on to your company stock is that over time it can grow too large and make up a significant part of your investment portfolio. This is called “a concentrated stock position”.
When your portfolio becomes concentrated, your portfolio is no longer diversified – investments broadly spread out among different assets. The benefit of diversification is if one part of your portfolio goes down, another part goes up.
If your portfolio becomes concentrated, a dramatic change in your company stock can have an impact on the entire portfolio. While this might not seem like a big deal if your company stock is rising but if it were to drop in price, your entire portfolio would lose value. This impact can be significant especially if you are nearing retirement.
How to Avoid Risks of Owning RSU’s
Restricted Stock Units can provide you with a great source of additional compensation. However, RSU’s are trickier to manage than a cash bonus as you have to manage the risks associated with holding stock investments.
To avoid having to manage the risk of investment losses or having a concentrated position in company stock, a prudent approach would be to sell your RSU’s immediately after it vests. The sell price and the exercise price will be very close and therefore, the tax impact will be minimal. In this way, your RSU’s become what is intended to be: other compensation.
The cash proceeds can be used to pay additional Federal and State taxes owed, supplement your salary, placed in safe investments like CD’s if you are saving for a house, or invested in a diversified portfolio of stocks and bonds as part of your retirement savings.
This content is developed from sources believed to be providing accurate information, and provided by Attune Financial Planning. Please consult your financial, legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information only.