Understanding Restricted Stock Units Vesting, Payouts, and Tax Implications

Employees and executives have a major impact on most business’s success, and many businesses strive to align the interests of their high-flying employees with those of their shareholders. Many companies issue company stock to their best and brightest (at WestStar we call them “Aviators”) as an incentive to stay long-term and help them perform.

When these businesses perform, their stock increases in value, and that’s the main attraction.

While most Aviators appreciate their stock-based incentive packages, they come with the responsibility to work like they’re invested, and this can mean many years of burning the midnight oil.

“Many Aviators view stock compensation as a form of quasi-golden handcuffs, locking part of their compensation into the typical 4-year vesting schedule. When companies rear-load their RSU vesting schedule it becomes financially tougher to switch companies. It is common for employees to live on their paycheck alone, and to under-prioritize the equity compensation component of their income. Over time this can create a dangerously undiversified portfolio and could result in greater risk, greater stress, and a reduced likelihood of them hitting their financial goals.”

Alex Fitch MBA, CRPC®, AAMS®: Financial Consultant

Restricted Stock Units (RSUs) are a common form of stock-based compensation that can be complex to understand and manage. Those who are compensated through RSUs may get caught up in the complexity that comes with understanding and optimizing their earnings.

What is an RSU?

In simple terms, a restricted stock unit (RSU) is a way in which a company gradually transfers company stock to employees.  They’re called “restricted,” because they can’t be transferred to those who earn them until certain pre-defined company or personal goals are met. These restricted stock units vest (their restrictions are removed) at set intervals over time, providing that certain goals are met. On vesting, the RSUs convert to shares, and the employee owns the shares and may sell or transfer them.

Employees know that by optimizing their RSU earnings (and minimizing taxes) they’ll turn their opportunities into success, but many are uncertain as to how to go about it.

“Most Aviators aren’t aware of what they can create when their RSUs are managed with personal and family financial goals, the timing of the grants, and navigation of blackout dates in mind. Many don’t know how to plan for the tax liability. Many are aware that they’re missing out and conscious of their risk; but their main challenge is time. They wish they could be more effective with their time and money. And that’s where we come in!”

Spencer Hill, MBA, Financial Consultant

So, what does this mean to anyone who holds these incentives?  Let’s unpack stock-based compensation, beginning with stock options.

What are Stock Options?

Stock options are the most common stock-based compensation incentive, and grant the holder a no-obligation right to purchase stock in a company at a future date, at a price established at the time of issue.

There are two main types of stock options – nonqualified stock options (NSOs) and qualified incentive stock options (ISOs).

Whereas employees and other service providers can be granted nonqualified stock options (NSOs), only employees may receive qualified incentive stock options (ISOs). While these stock options do not transfer an ownership interest upon holders, exercising them to acquire the stock does.

A qualified incentive stock option offers the additional reward of tax benefits on the profit. This is because the profit on qualified ISOs is usually taxed at the capital gains rate and not the higher ordinary-income rate. Whereas the tax liability of ISOs is triggered when the options are sold, NSOs trigger income reporting when the option is exercised.

At the point of exercise, ISO grant holders will pay the pre-set exercise price and acquire shares in the company. In cases where the fair market value (FMV) is higher than the exercise price, the larger the spread, the greater amount of income is added to the holder’s earned income to calculate their tax liability.

RSUs Vs Stock Options – What are the Differences?

Unlike ISOs and NSOs, Restricted Stock Units (RSUs) do not have to be purchased, and that’s because they are grants of stock a company pledges to employees in return for their efforts, tenure, and impact. Hence, your RSUs are a pledge by your employer to transfer units of company stock to you on future dates, providing that vesting conditions have been met.

While ISOs and NSOs are valuable only if the market value of the stock is higher than the grant price at some point in the vesting period, an RSU offers pure gain.

That’s because you don’t pay a dime to acquire them, and you only pay taxes if you choose to exercise the options on the vesting dates. These dates are set out in a vesting schedule.

Two dates to consider for RSUs are the grant date on which your company pledges restricted stock units to you, and the vesting date, when the restrictions are lifted and units become shares.

What makes RSUs so popular is the fact that this type of stock is taxed when it vests, and not when you receive it. Upon vesting, the underlying shares are considered income at the fair market price (FMV), and a portion of the shares is withheld to pay income taxes.

RSUs typically vest in tranches over a number of years.

After receiving your shares, your choice to hold or sell them is an investment decision and will depend on your view of the company and its growth prospects (we’ll cover this decision a little later).

 “We help professionals become financially confident through comprehensive financial planning and customized investment management. By using data and analytics, and staying innovative, we help our clients make informed decisions in pursuing the lives they want. It’s all about astute decision-making and timely guidance.”

Kevin Chang, Financial Consultant

To anyone with RSUs, it all seems like a complex management challenge, but there is a clear timeline that governs the process, and this is set out in your vesting schedule.

Why is the RSU Vesting Schedule so Important?

To recap, restricted stock units give you an interest in company stock, but have no real value until vesting is complete. Vesting is generally governed by a vesting schedule.

While RSUs and stock options often follow similar schedules, vesting details and specifics will mostly depend on the company in question, and the employee.

What is a RSU Vesting Schedule?

Your RSUs’ vesting schedule is often based on the achievement of personal and /or company performance goals. Vesting schedules may be governed by these and other transfers or sales limits that your company may impose.

The vesting schedule determines when you’ll be fully vested in (or acquire full ownership of) the company stock pledged to you. The restrictions, terms, and periods will impact the ultimate payout, and this will also depend on the type of vesting schedule (we’ll get to this a little later).

Your RSUs are taxed when they vest. Upon vesting, shares are considered income, and for tax purposes, the value of your vested RSUs must be included as income in the year of vesting.  Because the process is governed by your vesting schedule, it will pay you to stay on top of the timing of the grants and the transfer of shares, to plan for the tax liability.

How to Think About your Vesting Schedule

Think of your vesting schedule as a time-bound stock reward plan.  Over the vesting period, company stock will be awarded to you, whether on completion of time spent with the company, or on reaching pre-determined milestones, or meeting company goals.

When you receive these restricted stock units on your grant date, you can’t exercise your options until they fully vest. Vesting is a set schedule for when you can take advantage of your restricted stock options. Most companies follow a vesting schedule of between 3 and 5 years, though the structure varies by employer.

What are The Terms and Restrictions of an RSU Vesting Schedule?

Let’s talk a little about the restrictions governing restricted stock units. The restrictions aren’t necessarily there as a limitation: in fact, they’re an ideal way to reward employees for their loyalty and performance, and to link this reward to overall company performance, so everybody wins.

Your vesting schedule governs the terms of your RSU grant and may have to do with a given time period, company and individual performance, and other terms and conditions that will result in ultimate payout to you.

Vesting schedules apply to almost all stock-based compensation packages (including RSUs), and these are the types of schedules that are most commonly used:

• Time-Based Vesting (includes Cliff Vesting)
• Graded Vesting
• Performance-Based Vesting
• Mixed Vesting

How does Time-Based Vesting Work?

As the name suggests, a time-based vesting schedule is a method of vesting through which you earn your restricted stock units over time, usually based on a set schedule and a one-year cliff, which is the time when your first option may be exercised.

How does Cliff Vesting Work?

Time-based vesting plans typically have a 3-5-year vesting schedule with a 1-year cliff.

Rather than becoming partially vested in increasing amounts over an extended period, cliff vesting is when you become fully vested on a given date. Having completed the cliff period, you receive full benefits.

Under a standard 4-year time-based vesting schedule with a one-year cliff, 1/4 of your shares vest after 1 year. Over the ensuing 3 years, each month you will receive 1/36 of the remaining shares until the 4-year vesting period is over. You are fully vested after 4 years.

How does Graded Vesting Work?

Graded vesting is another type of time-based vesting in which you receive a given percentage of vesting after each year of service.  Most graded vesting schedules span between 3 and 5 years.

A predetermined percentage of your RSU award vests at the first anniversary of your grant date, and on the same date over the subsequent years. Once each portion vests, you can sell or hold your shares. For example, you’re granted 4,000 RSUs and your graded vesting schedule spans five years. 20% of the grant (800 shares) vests each year on the anniversary of your grant date.

What is Performance-Based Vesting?

A performance-based vesting schedule means the employee’s RSUs will vest when the company (or employee) achieves stipulated milestones – like reaching a sales target or company valuation, or reaching a stage in a product development plan. If these targets are not met, the awards do not vest.

What is Mixed Vesting?

A mixed (or hybrid) vesting schedule incorporates elements of time-based and performance-based vesting.

Vesting, Payouts, and Tax Implications

Until they vest, RSUs have no actual value. Once vested, these units are considered income, and a portion of the underlying shares will be withheld to pay the income taxes incurred.

The units will then become standard shares and may be sold for their market value.

An RSU is taxed as ordinary income when it vests and converts to shares, and not when you receive it.

Your taxable income is equal to the fair market value of the shares transferred to you. For tax purposes, the entire value of vested RSUs must be included as ordinary income in the year of vesting.  In other words, your vested RSUs are seen as supplementary income by the IRS and will appear with your compensation income in your W2.

If the shares are sold immediately, there is no capital gain, the only tax due is on the income. However, if the shares are held beyond the vesting date, you’ll also pay a capital gain (or loss) tax when you sell them.

What about The IRS?

Compared to other forms of equity compensation, RSU’s tax treatment may be fairly straightforward, but it’s still important to understand and manage the tax effectively.

The IRS will require a covering tax on your vested RSUs. This will likely be paid with shares that are withheld by your company, and the amount will determine your RSU income.

State tax rules will vary on this, and there is a chance that tax projected may be higher than the withholding amount. This usually occurs if the holder of an RSU holds on selling – on the assumption that tax benefits will accrue.

If you sell straight after vesting, no additional tax applies. If you hold off for an assumed future gain, that gain will be taxed under capital gains.

This means that should the stock price decline, the value drops, and you’ll experience a loss.

For a deeper understanding of RSU taxes, dive into this post.

Your Restricted Stock Options are Just a Piece of Your Portfolio

The savvy way of looking at your RSUs is as a component of your greater investment strategy. As we’ve said before, after receiving RSU shares, your choice to hold or sell them is an investment decision and will depend on your company and its growth prospects.

In some cases, a decision to sell immediately after vesting, and invest further into a diversified portfolio – with a tax-wise plan – may set you firmly on track to achieving your financial goals and minimizing risk.

In others – particularly in high-growth sectors – where your company is performing and looks to have a bright future, it is best to hold them.

While diversification is a well-practiced and widely accepted investment approach, a concentrated approach may be more suitable for different market segments.

 “Designing your financial flightpath becomes exciting and rewarding with clear communication and collaboration. We start with analysis, work our way towards portfolio design, and continue with regular reviews and frequent adaptations when these are needed.  Through this holistic planning process, we deal with the prioritization of savings, portfolio balancing, identifying opportunities with appealing risk and reward ratios, and mitigating taxes. We help our clients to understand their paths ahead and avoid barriers to success.”

Alex Fitch MBA, CRPC®, AAMS®: Financial Consultant.

How to Optimize Stock, Minimize Tax, and Master Your Investments

RSUs present a noteworthy complexity, but offer significant rewards to those who manage them well.

Conversely, these rewards become missed opportunities that can be costly. The trick is to know the rules and restrictions, and precisely how your RSUs can be of greatest benefit to you.

Click here to learn more about optimizing your RSU position with WestStar’s Aviator NavAid.

Why hitch your wagon to WestStar?

Impressive achievements are not accidental occurrences. If you’re seeking practiced guidance on how to optimize your restricted stock compensation, our financial consultants will help you turn the complex challenges into a clear flightpath to follow.

Don’t hesitate to get in touch.

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We wish you every success in the future and hope to hear from you soon.

Sam Gullette & Erik Alexander

Disclosure: “A diversified portfolio does not assure a profit or protect against loss in a declining market.”