Many employees receive restricted stock units (RSUs) as a part of their compensation, particularly in the tech industry.
In order to make employee compensation more manageable for tech companies, at least a portion of it can be paid in the form of stock. In addition to reducing the amount of cash, employers have to give out, this type of compensation serves as an incentive for employees to perform well.
RSUs can be a little tricky to understand, unfortunately. You're not alone if you're confused about what exactly you own and how it's taxed.
Do you receive restricted stock units as part of your compensation? Here's what you need to know about restricted stock units and their tax treatment.
What is a Restricted Stock Unit?
Restricted Stock Units are a little different from traditional restricted stock. Essentially, restricted stock is a gift of stock given to an executive of the company, while RSUs is a promise of future stock.
Individuals who are granted RSU stock must meet certain requirements, just like those who receive restricted stock. You may have to meet company or personal performance targets, but usually staying with the company until the vesting date is all that is required for receiving RSU stock.
As part of a restricted stock unit arrangement, the employee does not receive stock until he meets the vesting schedule or other requirements. As a result, holders of these stock units do not have voting rights until the shares themselves are officially transferred to them. This does not occur during the vesting period.
If you receive an RSU, there is no immediate tax liability. Taxes are only due when your RSU vests and you receive actual stock shares. Afterward, you must report income based on the fair market value of the stock.
Types of RSUs
RSUs can be offered with different restrictions by employers. Some RSUs are subject to only a vesting schedule and are referred to as single-trigger RSUs. In some cases, additional conditions must also be met along with vesting; these are called double-trigger RSUs.
Single-trigger RSUs: time-based vesting
Imagine you have been granted 1,500 RSUs, and the vesting schedule is 20% after one year, and then equal quarterly installments for the next three years. If you stay with the company for a year, 300 shares will vest and become yours. As long as you remain employed by the company for the next three years, you will receive 100 shares every quarter.
A graded vesting schedule is illustrated in the above example, with periodic grants vesting over time. Employers can also use cliff vesting, where all grants vest at the same time. For example, all 1,500 shares vest after three years. Your grants do not have value until their vesting date.
Double-trigger RSUs: performance-based goals
In addition to vesting schedules, RSUs can have other restrictions related to performance. It may require the company to reach certain milestones, such as launching a new product or service or to undergo a liquidity event, such as a merger, acquisition, IPO, direct listing, or SPAC listing.
How is RSUs Taxed?
Restricted stock units are technically a promise of future stock. As a result, you own nothing, and the IRS won't tax you until you do. As soon as your vesting period ends, your stock units become real. This is when your stock becomes yours. After this date, your stock becomes yours without restrictions. This is known as the vesting date.
As part of your compensation from your employer, your new stocks are taxed as ordinary income. Upon vesting, the IRS will tax you on the value of your shares.
Your tax liability ends if you sell your shares as soon as you own them. You may have to pay more tax if you choose to keep your shares. Any stocks you keep are now like any other stocks you own. When you sell them, you will have to pay capital gains tax (or claim a loss). If you keep your shares for less than a year, you'll be taxed at the short-term capital gains tax rate. You'll be subject to a more favorable long-term capital gains tax rate if you keep the assets for over a year.
Helpful Resource: Long-term vs short term capital gains tax
Some restricted stock unit plans allow you to choose your grant date for tax planning purposes. You will receive your stocks on this date, which may differ from your vesting date. The date you take possession of your stock can help you figure out when you'll have to pay tax on the issuance of the stock, but few plans offer that benefit. Understand your company's tax rules so you don't get surprised with a tax bill.
RSUs are taxed just like if you received a cash bonus (on the vesting date) and used that money to buy your company's stock.
Tax at vesting date is: # of shares vesting x price of shares = Income taxed in the current year
Tax, when shares are sold (if held beyond vesting date), is: (Sales price – price at vesting) x # of shares = Capital gain (or loss)
Tax Liability of RSUs
RSUs do not become yours until you meet any vesting requirements and other conditions. Due to the fact that you do not technically own the shares yet, there will be no tax consequences. Once your shares vest, a tax liability arises.
Shares you have vested in are worth the number of shares times their fair market value. You will be taxed on this value, and your company will be required to withhold the appropriate taxes.
You might be able to offset your tax liability by reducing the shares received by the amount of tax owed. Other companies may not offer this perk, requiring the employee to pay taxes upon vesting in cash.
What is the tax rate for an RSU?
Upon vesting, your stock's fair market value is taxed at the same rate as your ordinary income. Your tax rate will depend on your specific tax bracket based on your income.
Helpful Resource: Federal Income Tax Brackets and Tax Rates
If and when you decide to sell your stock later, you will owe tax based on whether you held the asset for a short or long period of time.
Ordinary Income Tax vs. Capital Gains Tax
When RSUs are issued to an employee or executive, they are subject to ordinary income tax. Capital gains tax only applies if the recipient of RSUs does not sell the stock immediately and it appreciates in value before it is sold.
Ordinary Income Tax: RSUs are taxed at ordinary income rates when issued, typically after vesting.
Capital Gains Tax: Capital gains tax is imposed only if the stockholder holds on to the shares and they appreciate in value before being sold. Capital gains tax is imposed on profit - the increase in value as a result of appreciation.
Are RSUs Taxed Twice?
There is no double taxation on RSUs. Despite this, it can seem that RSUs are taxed twice if you hold on to the stock and its value increases before you sell it. You are taxed at the ordinary income tax rate as soon as they vest and you own them.
Capital gains tax can apply to RSUs, but only if the stockholder decides not to sell the stock and its value increases before the stock is sold. The stock will have to be taxed on the gain if it increases in value after you have paid ordinary income tax on it and if you sell it at a profit in the future.
Section 83(b) Election
Those with restricted stock may elect to report the fair market value of their shares as ordinary income on the date that they are granted, rather than when they become vested. Capital gains are still taxed, but they are taxed at the time of grant. Since the stock price at the time the shares are granted is often lower than the price at the time of vesting, this election greatly reduces the amount of taxes owed. In particular, this strategy can be useful when there is a longer period of time between the grant of shares and the vesting of those shares, typically five years or more.
When is RSU income taxed?
You are taxed only on your RSU income when your shares are fully vested. It is important to remember that an RSU is nothing more than a promise that you will receive stock in the future and that the IRS does not tax promises. Until you own stock outright, you will not have to pay taxes on it.
Will RSU income appear on my W-2?
Yes. In the year you become vested in the plan, your stock will appear as income on your W-2. W-2s will also include any RSU taxes that were withheld for you by your employer.
As stock grants and RSUs are essentially compensation, they are usually reported automatically on your W-2. Withholding taxes are usually used to offset what you might owe when you file your taxes. As with any withholding, the taxes your employer deducts from your paycheck may not be enough to cover the full amount you owe to the IRS when you file your return.
You may be responsible for estimated taxes if your employer does not withhold tax on your stock grant or RSU. To pay estimated taxes, you must send the IRS payments about every quarter, typically on April 15, June 15, September 15, and January 15 of the following year. Payments are estimates of how much you will owe when you prepare your tax returns for that year.
Helpful Resource: What are estimated taxes?
How To Read RSUs on Form W-2
RSU values are typically recorded in Box 14 of the W-2, which is labeled "Other." Box 14 doesn't have a standard list of codes, so employers may enter any description they choose. There may be a "RSU" next to the value of your vested stock.
Since RSUs are considered wages, they're also included in Box 1 of your W-2, which reports your wages.
Strategies to Manage your RSU taxes
Adjust your withholdings with HR
The easiest way to make sure you're paying enough in taxes is to adjust your withholdings. Contact your Human Resources representative or whoever manages stock compensation at your company. Adjust your withholdings according to your marginal tax bracket, or, the highest tax bracket that your pre-RSU compensation will reach.
When you're between tax brackets, you can select the higher withholding for a tax refund or the lower withholding for a bit of extra savings.
Sell RSUs upon vesting
In essence, this is the same strategy as Option 1, except you are executing the trades, rather than them happening automatically.
You can use this method to make sure you pay your taxes without having to worry about large fluctuations in the stock price impacting your ability to do so.
RSUs do not create a tax burden unless the stock price has changed since the RSU vested. No matter whether you sell or hold the RSU, you will be taxed on the full value of the shares. Capital gains taxes are triggered when the price at which you purchased the RSU (the vesting price) differs from the price at which you sell the RSU.
To avoid any tax penalties, it is highly recommended to consult a CPA to determine your obligations. When you have significant tax obligations, using the proceeds from your stock sales to pay quarterly estimates to the IRS and your state is a good idea.
Sell RSUs at tax time to meet your tax obligations
You may want to wait until tax time to sell your shares if you believe the stock price will continue to rise. It can be advantageous if your stock price does continue to rise but can be a risky strategy since you are taking the risk of having to sell during a very specific period of time.
Throughout the year, keep an eye out for any closed trading windows that might prevent you from trading, and consult with an accountant to ensure that you won't be charged tax penalties for underpaying.
Getting Help With RSU Taxes
RSUs and restricted stock can be difficult to navigate from a legal and tax perspective. In most cases, RSUs and other forms of employee compensation are outlined in a legal agreement that may be hard to understand completely.
It is important to consult a financial advisor and tax advisor if there is any uncertainty so that the recipient understands what they are getting and how the taxation works.
When designing your strategy for holding or selling, you may find it beneficial to consult with a professional to develop your plan of action.
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