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Restricted Stock Units (RSUs) are a popular form of equity compensation to retain talent. If you receive RSUs as part of a compensation package, they can become extremely valuable if your company grows, but they can also result in a tax bill once you own the stock. In this article, we’ll explain RSUs and how to best minimize your tax liability on any RSUs you may have now or in the future.
Table of contents
- What are Restricted Stock Units and how do they work?
- Private company RSUs
- What are double-trigger RSUs
- Public company RSUs
- How are RSUs taxed?
- RSU taxes upon vesting
- RSU taxes upon the sale of vested stock
- FAQs about Restricted Stock Units
What are Restricted Stock Units and how do they work?
As a popular form of equity compensation at small startups up to large publicly traded companies, it’s important for employees to understand what Restricted Stock Units are and how they work.
What is an RSU?
A Restricted Stock Unit (RSU) is a form of compensation issued by an employer to an employee in the form of a grant of company stock. RSUs are “restricted” because they are subject to vesting conditions, typically based on continued employment or achieving certain performance milestones.
How do RSUs work?
With RSU compensation packages, employees receive the RSUs on what’s called the grant date. Then, once certain requirements are met, employees gain access to sell their RSU shares after the vesting date.
- Grant date: On the grant date, RSUs are awarded as equity compensation to employees who will receive the shares of company stock only after certain conditions, detailed in a vesting schedule, are met.
- Vesting requirements: Typically, a vesting schedule is time-based over three to four years, and may have an event-based condition as well (e.g. the IPO of the company), which is known as a double-trigger RSU.
- Vesting date: Unlike stock options, RSUs do not need to be purchased—when the vesting conditions are met, they become the property of the employee and will result in income taxes being owed on the 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 typically a change in corporate control event, including an Initial Public Offering (IPO), a tender offer, or a 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.
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. It’s common for private companies to use double-trigger RSUs instead of single-trigger RSUs to avoid having their employees pay taxes upon vesting without being able to trade or liquidate shares.
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 to 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?
Paying taxes on Restricted Stock Units can be complex, given the unique rules that apply at different stages. Since you don’t own actual shares with a restricted stock unit until vesting, you will not pay taxes on the grant date. Rather, RSUs will result in income tax consequences upon vesting and capital gains taxes upon the sale of the stock. Each event is subject to different tax burdens, which are detailed below to provide a clearer understanding of how your stock compensation might impact your tax bill.
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RSU taxes upon vesting
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. However, 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, 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 federal and state tax payments for that income. Quarterly estimated tax payments are typically needed for any non-wage sources of income. However, while vested RSUs are technically included in your wages, the withholding from your employer may not be sufficient and could result in the need for quarterly tax payments.
RSUs and Alternative Minimum Tax (AMT)
Since RSUs are treated as ordinary income, they may increase your taxable income above the exemption level that triggers the Alternative Minimum Tax (AMT). As of 2024, if your RSU income qualifies you for AMT, you’ll pay either a 26% or 28% tax rate with the AMT exemption phasing out for certain high-income taxpayers. For a deep dive into Alternative Minimum Tax (AMT), check out our updated 2024 guide.
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.
RSU taxes upon the sale of vested stock
Capital gains are the profits made from selling your vested RSU shares relative to the shares’ value, known as the cost basis, at the time of vesting. Those profits are then subject to the capital gains tax.
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 qualify for long-term capital gains, shares must be held for at least one year from the date of vesting.
What are the capital gains tax rates 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 vesting date to qualify for long-term capital gains taxes.
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.
FAQs about Restricted Stock Units
Is it better to take RSUs or stock options?
You won’t always have a choice, but the decision between RSUs and stock options depends on multiple factors including an individual’s risk tolerance, a company’s growth potential, and personal tax implications. RSUs represent company shares given to an employee as part of their compensation, vesting over time, and taxed as income when they vest. Unlike stock options, RSUs don’t require you to pay an exercise price to acquire the shares. Stock Options provide the right to purchase company shares at a set price, potentially offering higher rewards if the company’s stock price increases significantly, but they can carry more risk, as they may end up worthless if the stock price falls below the exercise price. Both RSUs and stock options have different tax treatments. Ultimately, personal financial goals, risk tolerance, and confidence in the company’s future performance should guide your decision. Talking with an equity tax advisor can help decide between choosing RSUs or stock options.
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 align employee and company interests, creating a straightforward way for companies to incentivize employees with equity compensation. For employees, RSUs reward loyalty and provide potential financial gain as companies grow with no upfront cost. Unlike stock options, RSUs hold some value even if the stock price falls below the grant price.
Harness can help you navigate RSUs
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. 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.
