Restricted Stock Units
Restricted stock units have become a popular vehicle to incentivize and reward highly valued employees of publicly traded companies.
*Important to note, restricted stock units are different than restricted stock awards, and we’ll be covering restricted stock awards in our next video and article.
What are Restricted Stock Units (RSUs)?
Restricted stock units are the promise of receiving stock at a future date.
Let’s review an example to highlight the mechanics:
A new Microsoft employee may receive RSUs as part of their compensation. An example may be receiving an offer of $150,000 as a base salary, and then in addition, receiving 500 shares of restricted stock units.
What does this mean?
This means the new employee has received the promise of 500 shares of Microsoft stock. Until the shares actually convert to the employee, they technically do not have any value though.
It’s important to know that not all of these RSUs come to you at once. Typically, you will be given a vesting schedule that outlines the timing and requirements for those shares truly becoming yours and obtaining value. For example, Microsoft’s plan provides that 25% of the shares vest in the first year, or 125 shares using our example of 500 total, and then 375 shares over four years at 6.25% of shares per quarter.
Vesting schedules can vary and understanding your schedule will prove a valuable first step.
How do Restricted Stock Units Impact Compensation?
I mentioned before that RSU’s are not really your shares until they vest. This detail impacts your compensation as you will not report income or owe taxes on RSU’s until vesting takes place.
Let’s revisit the 500 shares of Microsoft that new employee was granted.
Let’s fast forward through this employee’s career. It is just after year one, and 125 shares have vested.
Microsoft’s share price is now $226. This employee received a benefit worth $28,250 (125*$226). This income gets reported in the year the vesting takes place. The income is treated as ordinary income. Think of it just like receiving an additional paycheck. In this case, a paycheck worth $28,250.
Your company will actually help you with this to some extent.
There is going to be an automatic withholding requirement. In most cases, your company is going to withhold 22% automatically for federal tax, and often times 7.65% for FICA Tax. If your vesting could be worth over 1M you will likely see federal withholding of 37%.
How will they Withhold that Amount?
Typically, they will withhold a number of your shares in order to pay the tax.
This tax withholding often bothers people who think they are somehow losing out as they now see their dollar payout drop meaningfully, but remember, even if you were to receive a cash bonus instead of Restricted Stock Units, you still would have to pay taxes on it, so there is no “short change” whatsoever.
Where do the Shares Go?
After the shares vest you receive them and now own them just like any other individual stock. The same rules of short term and long term capital gains and losses will apply, with your holding period starting upon vesting.
Your company will likely partner with a brokerage firm where these shares will be held on your behalf. For instance, in the previous example, I happen to know that Microsoft partners with Fidelity. Any Microsoft employees with RSU’s receive a Fidelity brokerage account. Shares are deposited in the account where they can either keep or trade them through Fidelity’s platform.
Notice that the amount automatically withheld is a standardized amount. The dollar amount may end up being too much or too little, depending on your personal tax situation. Often times, it will be too little. This becomes especially true if you are in a high income tax state like California, since no state tax is withheld. A lack of proper tax planning can cause significant frustration and it will likely be practical to set some additional funds aside for tax season.
Leaving the Company Prior to Vesting
Using our Microsoft example, if that employee were to leave the company after only their first year of service, they would forfeit 75% of their RSU’s, or 375 shares.
Potential Growth of Restricted Stock Units
RSU’s hold a lot of potential when it comes to financial growth, whereas a regular cash bonus typically does offer the same appreciation opportunity.
Using Microsoft as an example again, their stock currently trades around $226.
Microsoft started the year at about $160 per share. Let’s compare. If Microsoft provided a cash bonus upfront of $80,000 (500*$160), that amount would be much less than if you received shares, now worth $113,000 (500*$226). You made out significantly better thanks to the appreciation of the equity.
This is exactly how RSUs are supposed to work. The theory is that you will help the company succeed and in turn the stock price will appreciate, thus rewarding you for your work and aligning your upside interest with the company’s. Of course, we have to recognize the risk that the stock price can lose value as well. This reality is why proper planning proves so valuable.
Some practical advice
What if I already Have Many Shares of the Company?
This can be a common problem. If you already have a sizable amount of shares and exposure to the company, you may want to turn around and sell those shares and reinvest them into something else immediately upon vesting. Consider a sizable position as one that represents 5% or more of your total net worth. If you lack decision making capabilities at the firm, this amount of exposure is often introducing a higher level of risk than the majority of prudent investors feel comfortable with.
The first step to properly planning around your RSUs is understanding your vesting schedule. With this information assessed, you can begin to project your income and potential tax liability and make plans accordingly. Will you use your payout for a major purchase? Pay down debt? Add to your investment account? I encourage you to develop your strategy so you can take advantage of this powerful wealth building benefit.
While I hope you found this information helpful, if you have any questions about your RSUs or employee benefits I will be happy to chat.