How Do Restricted Stock Units Work?
A restricted stock unit (RSU) is a form of stock-based compensation used to reward employees. Restricted stock units will vest at some point in the future and, unlike stock options, will have some value upon vesting unless the underlying company stock becomes worthless.
RSUs can be an important part of your clients’ compensation packages. They can help your clients build significant wealth. As a financial advisor, you can assist a client in getting the most out of this portion of their compensation.
- Restricted stock units are a type of stock-based compensation awarded to employees.
- RSUs initially have no financial value, but are a promise to the employee that they will receive stock at a specified time in the future.
- RSUs are structured to vest when a certain period of time has passed or when certain milestones have been reached.
- Once the RSUs vest, employees receive underlying shares of company stock.
- RSUs will have financial worth unless the underlying stock has no value.
How Restricted Stock Units Work
As a financial advisor, it’s important to understand RSUs so that you can properly advise your clients should they receive them.
Restricted stock units represent shares of a company’s stock. An employer sometimes grants them to employees as a form of compensation. RSUs are restricted by a vesting schedule that controls when units become actual shares that are placed in an employee’s account. A vesting schedule is based on length of employment or on performance milestones.
RSUs and, ultimately, the shares received may also be restricted by a company in other ways. For instance, there may be specific limits on transfers or sales.
RSUs have no actual financial value to the employee when issued. However, once they vest, employees can receive shares of stock or, less commonly, an equivalent value in cash.
Until the RSUs vest, they remain an unfunded promise to compensate the recipient at some point in the future. Holders of RSUs have no voting rights nor do they receive any dividends paid. Some companies may elect to pay dividend equivalents. For example, they may let dividends accrue and allocate those funds to cover some of the taxes due at vesting.
Usually, vesting halts if the employee is terminated. In the event of employee death, disability, or retirement, vesting may continue. This is controlled by the actual plan and grant agreement.
Should a client retain the shares or sell some or all of them? Like most such questions, the answer will depend on each client’s unique situation.
Once RSUs vest, an employee receives shares of company stock. Your client should take into account all other shares of company stock they hold in taxable and retirement accounts. If the employer’s stock is a steady performer, a client may be tempted to hold the stock—after all, there was no cost to obtain the shares.
A decision to hold the shares upon vesting means holding company stock valued at a particular price. If the shares have already appreciated greatly, a client may feel that there’s still upward price action to come. Or, they may decide that selling some or all shares is more worthwhile for them financially.
RSUs and Diversification
Many financial advisors caution against holding more than 10% of a portfolio in company stock.
Any concentrated stock holding is risky, but when it’s an employee’s company stock, they could run a two-fold risk if the company falls on hard times. For instance, losing one’s job in a downturn and holding stock that’s lost a great deal of value could mean a stiff financial hit.
It may be wise to think of RSUs as a cash bonus. Employees could then decide whether to hold company stock or sell it and invest the proceeds elsewhere for the purpose of diversification.
Death or Disability
Many company plans differ on what happens to RSUs in the case of death or disability. Don’t assume that the same treatment of other benefits and compensation applies to RSUs. Consider recommending that a client find out specifically how this works from their company’s benefits department.
Once RSUs vest and the shares are distributed, an employee will owe federal and, if applicable, state taxes on their value.
RSUs and Vesting
Restricted share units typically are accompanied by a vesting schedule. This could be a graded schedule or cliff schedule. The schedule establishes an amount of time that must pass before shares are distributed and can be sold. Additionally, specific financial milestones may need to be met before employees may sell their shares.
An employee receives 10,000 RSUs. The vesting schedule extends for four years. Each year on the anniversary date of the grant, a quarter of the total RSU amount vests, in this case, 2,500 shares. Typically, once each amount vests, the employee is allowed to sell the shares.
Depending on the company plan, a graded vesting schedule’s distribution intervals can vary. So, with the example above, on the first anniversary date, the employee could receive 2,500 shares. However, subsequent vesting of the remaining 7,500 shares might occur more quickly. For example, 625 shares might be vested monthly during the following year.
The alternative to graded vesting is cliff vesting. Cliff vesting involves vesting the total amount of a grant once an employee has worked for a company for a specific period of time, say, two years.
Alternatively, cliff vesting might involve performance milestones for an employee or company (such as reaching a certain stock market price).
RSUs and Taxes
Employees are taxed when RSUs vest and shares are distributed. The value of the shares is determined by the market price on the day of vesting/distribution. Since this is compensation income, the company will withhold the taxes from the employee’s wages.
The withholding will include federal income tax, state and local taxes, if applicable, and taxes for Social Security and Medicare.
Employees who keep their shares and subsequently receive dividend payments must pay ordinary income tax on the dividend amounts.
If employees sell shares that have appreciated in value, they’ll owe capital gains tax on the difference between the sale price and the value of the shares upon vesting. The actual tax rate will be determined by whether there are long-term capital gains or short-term capital gains.
Some companies may have arrangements to handle taxes owed by employees at vesting. The typical approach is to have the employee surrender enough of the distributed stock back to the company to cover the taxes. The company then uses its cash to pay the payroll tax.
If a client is poised to become vested in a significant amount of shares in a given year, you can help them focus on minimizing the tax impact. For instance, it might be wise to lump deductions from prior or future years into the year of vesting.
RSUs vs. Stock Options
Stock options represent a right to buy (or sell) shares of stock at a particular price (the exercise price) by some future date. One stock option contract represents 100 shares of stock. A new company may grant stock options to employees to motivate them to stay and help build the organization.
In fact, stock options presented as compensation by a company that’s already public usually have a vesting schedule. Just like for RSUs, this stops people from leaving after only a short time with shares of company stock that may be valuable.
Unlike RSUs, stock options don’t involve a transfer of ownership. Employees who receive stock options must buy the underlying shares themselves at the exercise price. Often, they profit by then selling their shares at the higher market price.
|Key Differences: RSUs vs. Stock Options|
|Restricted Share Units||Stock Options|
|Shares are transferred to employee||Shares must be purchased by employee|
|Value of shares is stock’s fair market price at vesting||Value of shares is the market price less the exercise price|
|Once vested, company deposits shares in brokerage account for employee||Once vested, employee can exercise options and buy shares|
|Less risk of being worthless due to assignment of actual market value to shares||Greater risk of being worthless if market price is less than the exercise price or equal to it|
|Taxed as ordinary income when they vest (exception: 83(b) tax election)||Taxation and timing of tax depend on type of stock option; may be taxed as ordinary income when exercised or as long-term capital gains depending on when sold; alternative minimum tax may apply|
What happens if your client receives a job offer with a competitor before the vesting of some or all of the RSUs granted? You can help that client place a value on the RSUs which would be lost. That value could then be used as part of the compensation negotiation between the client and potential employer.
If there are significant unvested portions of RSUs, it may also behoove your client to stay with the current employer until they are vested.
At retirement, any vested RSUs belong to the employee. If they stand to lose RSUs with significant value, again, it may pay to continue working until the RSUs vest.
If your client’s employment with the company is terminated involuntarily, in all likelihood, any unvested RSUs will be forfeited.
The firm should have an employment agreement or RSU plan rules that address the treatment of RSUs in these and other circumstances. Once again, be sure to advise your clients to become familiar with such rules.
How Are RSUs Different From Stock Options?
Both are a type of employee equity compensation, but RSUs are given to the employee free of charge and only have financial value as actual stock shares once vested. Stock options give the employee the right to buy company stock at a specific price called the strike price. They have value only when the market price is higher than the strike price.
Are RSUs Better Than Stock Options?
RSUs have the advantage in that they are a type of compensation the employee is given. They don’t have to pay for them. Also, they have value as long as the stock’s market price is above zero. Stock options require the employee to finance the purchase and only have value when the market price has surpassed the strike price.
How Are RSUs Taxed?
They are taxed as ordinary income at federal and state tax rates, with taxes due once the RSUs become vested and are assigned a value.
The Bottom Line
RSUs can be a high-value component of a client’s overall compensation package and wealth building strategy. A financial advisor can provide valuable advice and planning assistance to clients who want to capitalize on the financial benefits offered by RSUs.
Consider emphasizing for your clients the importance of understanding how RSUs work and the role they may play in the compensation they receive over time.