In this article, we explain Restricted Stock Units (RSUs), their popularity as a form of equity compensation, and how to best minimize tax liability on any RSUs you may have now or in the future.
Table of contents
- How do RSUs work?
- Private company RSUs
- What are double-trigger RSUs
- Public company RSUs
- How are RSUs taxed?
- Withholding tax for RSUs
- Strategies to cover RSU withholding tax
- How does supplemental income impact RSUs?
- FAQs about Restricted Stock Units
How do RSUs work?
RSUs are a type of equity compensation where employees are granted shares of company stock and receive them after certain conditions are met. Typically those conditions are timed based on a vesting schedule of three to four years, and may have an event-based condition as well (e.g. the IPO of the company), the latter of which is known as a double-trigger RSU. Unlike stock options, RSUs do not need to be purchased—when the vesting conditions are met, they become the property of the employee at their Fair Market Value (FMV).
Private company RSUs
If you have RSUs in a private company or pre-IPO startup, the value of your shares will be based on the current 409A valuation. A 409A valuation is an appraisal that must be produced by an independent third party and is meant to reflect the current fair market value of the company.
What are double-trigger RSUs?
Double-trigger Restricted Stock Units (RSUs) are a unique type of equity compensation requiring two distinct events to happen before an employee secures complete ownership of their granted shares.
- Vesting Period Completion: The first “trigger” involves fulfilling the vesting schedule, a set timeframe (often 3-4 years) during which the employee must remain with the company to earn their RSUs.
- Liquidity Event: The second “trigger” is a significant corporate event such as an Initial Public Offering (IPO), tender offer, or company acquisition.
This dual-trigger mechanism differs from standard RSUs, where vesting alone leads to share ownership. One recent example of a company using double-trigger RSUs is Stripe, which chose to facilitate a tender offer in 2023 in order to meet the second trigger for nearly-vested employees.
Public company RSUs
If you work at a publicly-traded company, or if your startup recently went through an IPO, the value of your RSUs is determined differently, and you may receive them at different times depending on if your company is in a blackout period. The FMV is determined by the stock price at the time of vesting.
RSU Blackout Period
If your RSUs vest during a blackout period, they’re only released to you during the next open trading window. For example, if your company has a blackout period from June 15-August 15 and your shares vest during that time, they’ll be released on August 16. That release date will be when they’re reported through payroll and not necessarily on the vesting date. The rationale behind these periods is to prevent the misuse of undisclosed financial data in stock trading, which could potentially lead to accusations of insider trading.
How Are RSUs Taxed?
Navigating the taxation landscape of Restricted Stock Units can be complex, given the unique rules that apply at different stages. This complexity stems from two main taxable events to consider with RSUs: upon vesting and upon sale. Each event is subject to different tax considerations, which are detailed below to provide a clearer understanding of how your equity compensation might impact your tax obligations.
Capital gains taxes on RSUs
Capital gains are the profits made from selling your shares relative to what you paid for them. Those profits are then subject to the capital gains tax. There are two types of capital gains:
- Short-Term Capital Gains: These gains are from shares owned for less than one year at the time of sale.
- Long-Term Capital Gains: To achieve long-term status, shares must be held for at least one year from the date of vesting.
What are the taxes on capital gains on RSUs?
Short-term capital gains are typically taxed as ordinary income. Long-term capital gains are taxed at a rate of 0%, 15%, or 20%, depending on your taxable income and marital status. Long-term capital gains rates are likely the lowest tax on your company shares. In order to minimize your RSU taxes as much as possible, it’s typically advisable to hold your shares for at least one year after the exercise date to qualify for long-term capital gains taxes.
Withholding Tax for RSUs
RSUs are considered supplemental income, and as such, the income you receive from them is subject to withholding taxes. The IRS requires a federal withholding rate of 22% for supplemental income up to $1 million, and 37% for income exceeding that amount. However, your actual tax liability might be higher depending on your total taxable income for the year. If that’s the case, you may have to pay additional taxes when filing your annual return.
Most employers handle tax withholding for RSUs on your behalf by applying the ‘sell to cover’ strategy. This involves selling a portion of your RSUs as they vest to cover the tax liability. The remaining shares are then distributed to you. However, some companies may allow you to meet the tax liability out of pocket, allowing you to retain all of your vested shares but requiring you to have sufficient cash on hand. Alternatively, you can sell all of your vested shares immediately and use the proceeds to cover the tax liability. Any remaining proceeds after taxes are yours to keep.
The Withholding Period for RSUs
Once your RSUs have vested, you’ll likely be eager to sell your shares and cash out. But doing so requires the completion of a withholding period. The RSU withholding period in the context of RSUs refers to the time when your employer calculates the total income from the vesting RSUs based on the fair market value. This income is then subjected to mandatory tax withholding to cover both federal and state taxes. The duration of the withholding period is typically short and concludes when the correct number of shares have been withheld to cover the tax liability. The remaining shares are then deposited into your brokerage account.
Remember, the tax withheld during this period is only an estimate of your actual tax liability. Your actual liability could be higher or lower, depending on your total income and tax situation for the year. For this reason, it’s advisable to consult with a tax advisor to accurately plan for your tax obligations.
Strategies to Cover RSU Withholding Tax
The tax liability that arises from RSUs is often covered by withholding a portion of the vested RSUs. However, different methods can be employed to handle this tax obligation, each having distinct implications on your equity and cash flow. It’s vital to understand the “why” behind choosing these different options.
- Sell to cover: This involves selling a portion of the newly vested shares to cover the tax obligation. The remaining shares are then yours to keep. This method allows you to cover your immediate tax liability without any out-of-pocket expenses. However, you will own fewer shares in the long run.
- Same-day sale: With this method, you sell all vested shares immediately. Part of the proceeds cover your tax liability, and you keep the remaining cash. This approach helps you realize immediate liquidity, but it also means you no longer have ownership in the stock, removing potential upside if the stock price increases.
- Cash payment: You use cash to pay the withholding tax. This option allows you to keep all your shares for potential future gains, but it might strain your cash reserves, especially if the value of your shares is substantial.
Deciding between these methods depends on your financial situation and goals. If you aim to maximize your equity and believe in the company’s long-term growth, you might prefer to use cash for tax payments to hold onto as many shares as possible. Conversely, if you need immediate liquidity or wish to diversify your investment, selling shares to cover taxes could be more beneficial.
Given the significant impact of these decisions, it’s advisable to consult a tax advisor. They can provide a personalized strategy based on your situation. Harness Wealth, for example, can connect you with advisors who specialize in this area.
Quarterly Taxes on RSUs
When your RSUs vest, you may be required to make quarterly estimated tax payments to the IRS and state taxing authorities for that income. Quarterly estimated tax payments are typically needed for any non-wage sources of income. However, while RSUs vesting is technically included in your wages, the withholding from our employer may not be sufficient and would result in the need for quarterly tax payments.
With your regular salaried income, your employer already pays estimated state and federal taxes for you. When it comes to other forms of income (like vesting RSUs), there are no automatic estimated payments made. Therefore, on any income potentially subject to the Alternative Minimum Tax (AMT) or if you didn’t withhold enough for regular income, you may have to make quarterly estimated tax payments. However, if your regular income tax payments meet the qualifications below, you can delay your tax payments on AMTI until it’s time for your annual tax filing.
How Does Supplemental Income Impact RSUs?
Remember, the vesting of your RSUs influences your taxable income and can increase your effective tax rate. This rise in taxable income might affect your eligibility for certain benefits like the Roth IRA and Child Tax Credit. Always ensure your financial decisions align with your long-term goals and financial plan. Consult with a professional advisor for personalized advice.
Your tax strategy can have a substantial impact on your financial health. While navigating RSUs and their tax implications can be complex, a tax advisor can help you develop the optimal strategy to balance your immediate cash flow needs with your long-term wealth-building goals.
FAQs about Restricted Stock Units
- What is the difference between RSUs and stock options?
RSUs are a grant of company shares that are delivered once certain vesting conditions are met, typically over a few years. Unlike stock options, RSUs don’t require you to pay an exercise price to acquire the shares. Stock options, on the other hand, give you the right to buy your company’s stock at a predetermined price within a specific timeframe.
- What happens to my RSUs if I leave the company?
If you leave the company before your RSUs have vested, you typically forfeit those unvested shares. However, the terms can vary, so it’s essential to review your company’s specific RSU agreement.
- When should I sell my vested RSUs?
The decision to sell your vested RSUs should be based on your personal financial situation, your tax implications, and your beliefs about the future performance of the company’s stock. It’s generally advisable to consult a financial advisor or tax professional for personalized advice.
- Can I defer taxes on my RSUs?
Under most circumstances, you can’t defer taxes on RSUs. Taxes are generally due at the time of vesting based on the fair market value of the shares. Any subsequent growth in the value of the shares is taxed as a capital gain upon sale.
- What is the advantage of RSUs?
RSUs offer a way for companies to compensate employees with equity in the company, aligning their interests with those of the company. For employees, RSUs provide potential financial gain with no upfront cost, and unlike stock options, they hold some value even if the stock price falls below the grant price.
Work with a Harness Wealth Advisor
The value of vested RSUs can be life-changing, but it’s important to consider how they fit into a comprehensive, diversified personal financial plan. If you’re a startup founder or employee with RSUs as part of your equity compensation, and are expecting a liquidity event, consider working with Harness Wealth. Our Advisor Marketplace can connect you with wealth managers and financial professionals well-versed in equity compensation, and our 1-hour Equity Tax Planning Sessions can give you quick access to information pertinent to your unique financial situation.