Grants of restricted stock and restricted stock units (RSUs) are conceptually simple: awards of company shares that are subject to a vesting schedule, which can be based on time or performance. Once the grant vests, you own the shares and can hold them or sell them as you wish.
Planning for restricted stock and RSUs can be deceptively complex.
However, financial planning for restricted stock and RSUs can be deceptively complex. Should you hold the shares? If so, for how long? Should you sell the shares and put them into an alternative investment? Or should you simply sell the shares and use the proceeds to meet an important life goal? This article presents the essential financial-planning points that you should consider before your restricted stock or RSU grant vests.
Rule No. 1: Set Goals
All financial planning starts with setting goals. In granting you restricted stock or RSUs, your company is trying to motivate you and keep you as an employee. To that end, it wants you to understand the value of your grants and how they fit into your life. What exactly do you want to do with the proceeds from the eventual sale of the shares? Coming up with concrete goals will help to clarify your use of the shares in relation to your salary income and to your 401(k) holdings and other savings.
Rule No. 2: Know Your Vesting Schedule
You must know when your grant will vest, as this is when the underlying shares will become yours. Some surprises are fun, but with equity compensation they are seldom enjoyable and often involve taxes. When you receive the shares upon vesting, you will pay taxes on the resulting income (see the next section), and that requires some forethought.
For restricted stock, a vesting schedule dictates when the forfeiture restrictions on the shares lapse. With RSUs, it dictates when the shares are delivered to you. Vesting schedules are often time-based, requiring you to work at the company for a certain period before vesting can occur. Especially for executives, the schedule can also or instead be performance-based (e.g. tied to company-specific or stock-market targets).
Rule No. 3: Know What Would Happen To Unvested Grants If You Were To Leave The Company
With restricted stock and restricted stock units, job termination almost always stops vesting and causes the forfeiture of unvested grants—you lose shares that have not yet vested. Exceptions can occur, depending on the vesting terms of your grant agreement or stock plan, such as special provisions for disability or death, for retirement, or for a change in corporate control (e.g. a merger or acquisition).
You keep any shares that vested before your termination date. Therefore, if you are planning to leave your job, you may want to stick around long enough to get any valuable chuck of restricted stock/RSUs that may vest in the near future. Remember that there is nothing shady or unfair about this. You have made a contribution to the long-term value of the company, and you should be rewarded for that!
Rule No. 4: Understand The Taxation
Understanding the taxation of restricted stock and RSUs is a crucial part of the planning for these grants.
You cannot conceive a financial plan for restricted stock and RSUs without knowing the taxation of the grants. Your taxable income will be the market value of the shares at vesting. This is compensation income and is therefore subject to federal income tax, Social Security, and Medicare, plus any state and local tax. Your company may offer you a few ways to elect to pay taxes at vesting, such as the withholding of shares for taxes, a sell-to-cover transaction for taxes of a portion of the shares, a salary deduction, or simply a check payment.
Alert: Confirm that you have certified an IRS Form W-9 or Form W-8BEN for the account with your brokerage firm or transfer agent. If it does not have this form, you will be subject to backup withholding on the sales proceeds.
When you later sell the shares, you will pay capital gains tax on any appreciation over the market price of the shares on the vesting date.
Rule No. 5: Be Aware Of The Ability To Shift Taxable Income
With restricted stock only (never with RSUs), you can make what is called a Section 83(b) election with the IRS during the 30 days after the grant date. When you make an 83(b) election, you pay taxes on the value of the stock at grant instead of at vesting. This can be a good bet if you are confident you will meet the vesting requirement and if you have good reasons to believe the stock price will be significantly higher on the vesting date than it is on the grant date, making it beneficial to pay taxes on the lower value. Also, moving the time of taxation to grant starts the capital gains holding period earlier, which can make a difference at the eventual sale of the shares.
However, a Section 83(b) election carries risks, as you cannot recover the taxes you paid if you later forfeit the grant by, for example, leaving your job before the vesting date. For this reason, most people do not make Section 83(b) elections to be taxed at grant, but the election is a planning tool you should at least be aware of if you have an award of restricted stock.
As mentioned before, with RSUs you cannot make the Section 83(b) election, so you do not have this tax-timing choice. However, some RSU plans have a tax-deferral feature that allows you to delay the delivery of the shares (and thus the income tax on them) until a specific point in the future (e.g. retirement).
Rule No. 6: Watch Your Tax Rates
Anticipate what restricted stock/RSUs will do to your tax rates in the year when you recognize the related income.
You need to anticipate what restricted stock/RSUs will do to your tax rates in the year when you recognize the related income. The income spike can have a significant impact. Yearly income above certain thresholds temporarily lifts your income tax rate, raises your rate of capital gains tax on any shares you sell, and triggers extra Medicare taxes. Also, you may need to pay estimated taxes if your default withholding rate is not commensurate with your elevated level of income in that year.
Example: You have a big restricted stock/RSU vesting this year that will push your income into the highest tax bracket. You may want to think carefully before selling those or other shares (or exercising stock options) in the same year. While taxes should not dominate your decision-making, if you have no reason not to wait until a year when your income is at a normal level, you may want to avoid selling the shares and recognizing capital gains during this year's income spike. This can make the difference between paying 23.8% in capital gains tax plus the Medicare surtax and paying capital gains tax at a rate of just 15%, without the Medicare surtax.
Rule No. 7: Know Whether You Want To Sell Or Hold The Shares After Vesting
The decision about whether to sell or hold the shares received at vesting depends on various factors. Some of them are under your control.
- Taxes owed. Shares can be a source of the proceeds needed to pay taxes at vesting, whether through tax withholding, net share settlement, or a sale of shares for taxes.
- Tax planning. Whether you hold the shares and for how long will affect your capital gains tax at sale. Any holding period after vesting does not affect the amount of income tax due for the value of the shares at vesting.
- Your cash needs, upcoming life events, and other financial-planning factors, including diversification, dividends paid on your stock, and alternative investments.
- Whether your company is publicly traded or privately held. At public companies, be aware of blackouts when you cannot trade or stock ownership/retention guidelines that require you to keep a certain amount of company stock. In a privately held company, you will not be able to sell the shares immediately at vesting because of restrictions that are likely to exist in your grant and/or because of the SEC rules on resales.
If you are not comfortable with making these decisions on your own, discuss strategies with your financial advisor.
Rule No. 8: Consider Dividends
Even though you cannot transfer restricted stock until it vests, shares of restricted stock (but not RSUs) are issued to you and are outstanding in your name from the time of grant. Therefore, with restricted stock you typically do receive dividends.
RSUs are technically just a bookkeeping entry: no actual shares are issued to you until after vesting. Therefore, dividends cannot be paid on unvested RSUs. However, when a company pays dividends on outstanding shares of stock, it can choose to pay dividend equivalents on RSUs. These may be deferred or accrued to additional units and then settled when the unit vests.
Rule No. 9: Beware Overconcentration In Your Company's Stock, And Consider Diversification
The danger of overconcentration is especially easy to ignore if your company's stock price is rising strongly.
"Don't keep all of your eggs in one basket." This good advice neatly encapsulates the dangers of stock overconcentration and the importance of investment diversification. When you have grants of restricted stock or RSUs, as they vest over time it is easy to forget how much of your net worth is steadily accumulating in the single basket of your company's stock. The danger of overconcentration is especially easy to ignore if your company's stock price is rising strongly. However, market crashes in recent history have shown just how quickly any company's stock price can plummet.
Know how much your holdings in company stock contribute to your overall net worth. Try not to overthink or second-guess yourself about sales of stock for diversification. Even if the company's stock price continues to rise after your sale, remember that you still have made a profit. If you reinvest those funds in a diversified portfolio, you may still see an increase in value. Also, don't feel disloyal about selling your company's stock to avoid overconcentration.
Rule No. 10: Obtain Professional Advice On Financial Planning And Taxes, And Do Your Homework
Sound financial planning, investing, and tax management require specialized knowledge and skills that do not necessarily come naturally to human beings. Many very smart people are not DIY investors. Get professional help with financial planning for stock compensation and for the related taxes.