Let’s talk about restricted stock units, also commonly referred to as RSUs. Typically, they’re granted as an add-on to a person's salary at a public company. RSUs make up a part of an employee’s total compensation that may also include: a basic salary, a cash bonus, and maybe even some stock options. Think of RSUs as bonus income! While I believe RSUs are the most straightforward type of equity compensation, they are often misunderstood.
Remember: RSUs serve as an additional income to you, but instead of receiving dollars in your paycheck, you receive shares of your company's stock. Cash is generally pretty stable — a dollar is a dollar. However, your company's stock price may be volatile, so managing your RSUs and their taxation can be a literal nightmare. Let's dive into common misconceptions about RSUs to help understand them better.
Misconception #1: If I hold my shares for a year after they vest, I get to pay the lower long-term capital gain tax rate.
This is definitely not true. As a financial advisor, I hear this all the time: "I read that I should hold my shares for a year to get the lower capital gains rate of 15% instead of paying the higher short-term rate." Let's unpack this common misconception about RSU taxation.
Yes, it's true that when you hold an asset for one year and one day after you bought it, you get to pay the long-term capital gains rate. This rate is usually lower than the short-term rate, which is equal to the ordinary income rate, but when it comes to RSUs, the vesting date counts as the day you "bought" the shares. Yes, I know you didn't have to pay for your RSUs with money, but the RSUs were granted to you on the condition you remain employed at your company. As a result, it’s as if you bought them with the work you continue to do for your company.
You may be wondering, how are RSUs taxed? It’s actually more simple than you think. Because RSUs are classified as income, they’re taxed at the regular ordinary income rates when they vest — no matter what. On the day your stock vests according to your vesting schedule, those shares become income to you at the price the open market has determined for that day. Therefore, if the stock price was $50 yesterday, but it's $45 today — which is the day listed in your vesting schedule — sorry bud, you're getting one share that you might immediately sell for $45.
For example, let’s take a look at IBM, a public technology company founded in 1911, which was trading at $118 on 1/1/2021, but increased to $136 on its long-term capital gains birthday of 1/2/2022. Most folks may think they should have held that stock for a year, so they would only pay a 15% tax on the higher gain, but that's not how it works with RSUs.
The price on the vesting date is counted as income to you, and therefore taxable at ordinary income, or short-term rates. Using our IBM example, $118 is taxable to you on 1/1/2021. If you did decide to hold for a year after that, that's fine, but you only get to pay the long-term rate on the difference between the vesting price of $118 and $136, which is only $18 of gain. Therefore, you waited a whole year not to sell to save yourself about a dollar in taxes.
Misconception #2: When an offer letter lists a dollar amount value of RSUs, I get a portion of that dollar amount each time my RSUs vest.
This also isn’t true! Not only is this misconception confusing, it’s also misleading.
As a financial advisor in the equity compensation space, I see a lot of offer letters. Offer letters range from brief emails with a salary number to 75-page PDFs highlighting an RSU vesting schedule in painstaking detail. For example, you might get an offer letter that states, "$100,000 of RSUs vesting over 4 years with 25% vesting at the one-year cliff, then quarterly after that." So let's break it down.
You might assume that you would get $25,000 on your one-year anniversary, then $75,000 divided by 12 quarters every quarter after that, which is roughly $6,250 per quarter, but that’s not how it works.
The number of shares granted is determined on the grant date by taking the cash award value and dividing it by the share price on the day of the grant. Then, the number of shares is spread out according to your vesting schedule. Therefore, the value of the grant on day one is $100,000, but depending on how the stock performs, you could end up with much less or much more.
Misconception #3: When my RSUs vested, they sold way too many to cover the taxes. I barely got half of them, so there's no way I owe more in taxes.
Unfortunately, most people with vesting RSUs will owe additional taxes each year because, in fact, they are under-withheld. Here’s why: most companies default to withholding taxes from vesting RSUs at 22% which is the supplemental wage rate because RSUs are just plain old income paid in shares instead of cash. In fact, most companies will refuse to change your RSU withholding unless you have more than $1,000,000 of income.
That’s fine, except if you look back at the current tax brackets, you’ll quickly realize that those making over $85,000 in salary are actually taxed at higher rates than 22%. Therefore, even though their regular salary has the correct withholding to ensure they don’t owe additional taxes, the RSUs do not have the correct withholding. As a result, sometimes the results can be pretty dramatic.
Need assistance with RSUs?
If you find yourself grappling with the intricacies of RSUs, it's time to seek guidance from a knowledgeable financial advisor. With their expertise, you can navigate RSUs with confidence, uncovering strategies that maximize your benefits and propel your financial goals forward. Seize the opportunity to optimize your RSUs by partnering with a trusted advisor through FinanceHQ who can provide the clarity and insights you need.
