Many employees receive a significant amount of their income from restricted stock units (RSUs) or performance stock units (PSUs), both of which are taxed upon vesting and not at the time of grant. These grants are typically subject to a vesting schedule, most commonly a specific amount of service time and/or the attainment of certain performance goals by the company, giving the employee little choice around when a taxable event will take place. However, Section 409A of the Internal Revenue Code (Section 409A) generally allows for the deferral of both RSUs and PSUs, thus allowing the employee to control the timing of income recognition and avoid “forced” income from the award upon vesting. Permitting the deferral of RSUs or PSUs into a deferred compensation plan can be part of a strategic approach to help companies recruit, attract, and retain employees.
Why would companies allow for the deferral of RSUs/PSUs?
Companies offer deferred compensation plans to allow employees to save, on a tax-deferred basis, income beyond what might be saved in a qualified retirement plan. Providing increased income saving options can help reduce current taxable income for employees and help them feel more in charge of their own financial futures.
While the deferral of wages (i.e., salary, bonus and commissions) is quite typical, companies increasingly allow employees to defer RSUs and/or PSUs into a deferred compensation plan. In these cases, companies typically structure the deferral to continue to be treated as invested in company stock and then settle the obligation to the employee through the delivery of company stock rather than cash. This approach may simplify the company’s financial reporting by allowing for fixed accounting of the RSU/PSU plan liabilities.
Why do employees wish to defer RSUs/PSUs?
Taxable Income: The main reason employees may wish to defer RSUs/PSUs until a later date is to reduce their current taxable income and to have more control and flexibility over when taxation occurs. Employees who are highly compensated typically have more of their income taxed at a higher rate, and deferring payment of these awards can allow the employee to receive the income at a later date when they may be in a lower income tax bracket. Additionally, the deferred compensation plan may allow the employee to receive installment payments over multiple years, thus spreading out the taxable income over time.
Since income is fungible, employees may choose to defer RSUs/PSUs and live off their salary and bonus. Alternatively, they may wish to defer additional cash compensation to offset the income received when the RSUs/PSUs vest.
Stock Ownership Guidelines: Many companies will require certain employees to hold a multiple of their salary in the form of company stock. Companies will often count RSUs/PSUs held within a deferred compensation plan toward these guidelines, as plans often do not permit diversification away from company stock because of accounting issues that might apply. Using deferred RSUs/PSUs may help an employee reach their ownership more quickly. Since deferred RSUs/PSUs are deferred into the plan before they are taxed, employees receive 100 percent of the award in the deferred compensation plan, rather than the after-tax amount outside of the plan had the award not been deferred.
Building Wealth: Deferred compensation plans, like equity plans, are a major way for employees to build wealth through their employer-sponsored benefit plans. The flexibility and potential tax benefits of deferring RSUs or PSUs can help employees build their wealth and work toward their overall financial goals.
What are the timing rules for the deferral of RSUs/PSUs into a deferred compensation plan?
Generally, Section 409A requires RSUs/PSUs to be deferred before they are granted. Most companies will require a deferral election for awards in the year prior to the year in which they are granted. If PSUs qualify as performance-based compensation under Section 409A, the election to defer may generally be made as late as six months before the end of the applicable measurement period, so long as the amount that will be received is substantially uncertain. In some cases, RSUs can be deferred within 30 days after the grant date, so long as the vesting date is more than a year away, subject to certain exceptions. For an existing unvested stock grant, it may be possible to defer unvested RSUs that are more than 12 months out from vesting, but the distribution date must be at least 5 years from the original vesting date.
How are deferred RSUs/PSUs taxed to the employee?
At grant, there are no taxes due for deferred RSUs/PSUs. At each vesting date (the date upon which a portion of the award is no longer subject to a substantial risk of forfeiture), the value of the vested shares is generally taxed only for Federal Insurance Contributions Act (FICA) and Federal Unemployment Tax Act (FUTA) at fair market value. These obligations are typically satisfied from the portion of the employee’s salary not deferred in the plan and are due on or in the year of the vesting date. If an employee defers their RSUs/PSUs into a deferred compensation plan, they do not pay income taxes until the RSUs/PSUs are distributed from the plan, and the tax obligation can be satisfied by selling the necessary number of shares with a fair market value equal to the tax obligation.
Access to a Morgan Stanley Financial Advisor
Employees may have questions when determining, if it is allowed by their employer’s plan, whether to take the RSUs/PSUs upon vesting and hold the shares for capital gains, or to defer them until a later date. For plans where we act as recordkeeper, we make a Morgan Stanley Financial Advisor available to employees in these deferred compensation plans. Our Financial Advisors can help with holistic financial planning, taking into account the employee’s financial situation as well as other benefit plans sponsored by their employer. From these discussions, employees are able to make decisions around the appropriate way to participate in the deferred compensation plan, whether that is through deferral of equity awards or cash compensation.
