Understanding Restricted Stock Unit (RSU) Taxes

Restricted stock units (RSUs) are a common form of stock-based compensation granted to many professionals in tech and other fast-growth sectors (at WestStar we call them ‘Aviators’).  RSUs give Aviators an incentive to stay with the company long-term, and add as much value as possible.

When the company performs, its restricted stock units increase in value, and that’s where the incentive lies.

On the flipside, because their RSUs can contribute over half of their annual compensation, employees must gain a thorough understanding of how they work in order to reduce their tax bill and optimize their benefits.

Only by doing so will they target their financial goals with confidence and clarity.

Here’s how WestStar’s Erik Alexander sees it.

“We find our Aviator clients reach out to us based on their pain points of ‘how do I make the most of my stock compensation?’ and ‘What do I need to be prepared for tax-wise?’  Taxes are such a complex system in the US, so it really pays to understand what applies in a specific situation. And different types of stock and options can produce different tax implications, which makes it all the more difficult (and beneficial) to master.”

Erik Alexander, Financial Consultant

What is Vesting Stock and a Vesting Schedule?

Vesting is a legal term for the point in time where a person earns or gains property.

In terms of employee stock-based compensation, vesting stock refers to shares that are not yet earned by the employee. When RSUs become fully vested, the employee has earned ownership of the shares outright.

The “Restriction” in RSUs refers to the fact that they have a vesting schedule. When RSUs vest, their restrictions are removed and are converted to shares at set intervals over time, or when company (or personal) goals are met.

In practical terms, these vesting schedules require that the company or the employee meets stipulated goals before the employee gains the right to own the shares they’ve earned. These shares are only owned by the employee once they become fully vested.

It is worth noting that some new RSU types are not granted in shares of company stock: rather, they’re granted in dollars in the form of company stock. As an example, consider a grant of $100,000 in company stock. Instead of receiving the stock all at once, the employee is granted $5,000 in stock year 1; $15,000 in stock year 2; $40,000 in stock year 3; and $40,000 in stock year 4.

That may sound strange and unfamiliar, but it essentially removes the effects of market growth or market losses from the company stock during the vesting years.

Restricted Stock Awards (RSAs) are another form of restricted stock, and are essentially RSUs without the vesting schedule.

For a deeper dive on the various types of vesting schedules, read this article. [Link to How to Manage Your Restricted Stock Units (RSUs)]

How are Restricted Stock Units (RSUs) Taxed?

Unlike the tax liability of incentive stock options (ISOs) – which is triggered when the options are exercised – your RSU tax liability is triggered once your RSUs vest. When your RSUs vest, their ownership is transferred to you, and you immediately have a tax liability on the value of your stock. Once your RSUs convert to shares, you own the shares and may sell or transfer them immediately.

How does this Look in Practice?

WestStar’s Aaron McDermott explains:

“Consider if you’re granted $20,000 worth of RSUs and they fully vest in the 2023 calendar year, you’ll have a tax liability on your $20,000 worth of stock – which will be at the ordinary income rate in the year of vesting. 

Your taxable income is equal to the fair market value (FMV) of the stock transferred to you. For tax purposes, the entire value of vested RSUs must be included as ordinary income. If the stock is sold immediately, there is no capital gain; the only tax due is on the income.

However, your RSUs can also be subject to capital gains tax, if the shares are held beyond the vesting date. In this instance, depending on any gain or loss in the stock price over the period before you sell them, you’ll also pay a capital gain tax when you sell them. Here’s a simplistic example of how this could look in reality.

If you are granted $15,000 worth of RSUs as part of your compensation package, you will pay ordinary income tax on $15,000 when they vest. If you choose to hold $5,000 worth of stock and the stock increases to a value of $7,000, you will need to pay an additional capital gains tax on the $2,000 value increase.’”

Aaron McDermott, Financial Consultant

The impact of Supplemental Income on Your Tax Bill

Since the IRS considers RSUs supplemental income, if your supplemental income is greater than $1MM, 22% of your income is withheld. If it is less than $1MM, withholding tax will be 37%. This means high-income earners can be subject to a tax rate upwards of 50% on their RSUs.

Is it Better to Hold or Sell Your Shares?

After receiving restricted stock units, your choice to hold or sell your units is an investment decision and will depend on the company and its growth prospects.

In some cases, it may be best to sell your shares when you receive them, and add the proceeds to a well-diversified investment portfolio. In others – where your company is performing well and looks to have a bright future – it may be best to hold them.

Are Restricted Stock Units Taxed Twice?

RSUs are not taxed twice, but it can seem like they are if you choose to hold the stock and it increases in value before you sell it.

After they vest, your RSUs are taxed at the ordinary income tax rate. If you choose not to sell them immediately, your RSUs can trigger capital gains tax when you sell the stock at a future date.

If your stock increases in value before you sell it in the future, you will pay a capital gain tax on that profit.

This example outlines both tax scenarios, demonstrating that RSUs are only taxed once:

“You’re a highflyer working for a fast-growth company and you receive RSUs as part of your compensation package. You have $20,000 worth of RSUs vest in 2023, meaning you own the stock outright. You now have a tax liability on the $20,000 worth of stock, which will be taxed at the ordinary income rate.

To pay the tax, you choose to sell half the stock immediately and hold $10,000 worth of stock. The $10,000 worth of stock appreciates by $2,000 in 2024, before you sell your position for $12,000. You are now liable for paying capital gains tax on the $2,000 appreciation. Because this $2,000 value gain was not value granted in your original RSU issuance, it was not previously taxed at ordinary income rate.”

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

To conclude, capital gains tax comes into play only if you choose not to sell your stock immediately and it appreciates before you sell it.

For more on how to incorporate RSUs into your investment strategy and avoid concentrated stock risk, dive into this article. 

How Long should I hold my Stock if I Elect to Do So?

Providing you hold your stock for more than 1 year, you will be taxed at the long-term capital gains rate (a lower rate than the ordinary income rate). Should you hold your stock for less than 1 year, you’ll be taxed at the short-term capital gains rate (which is the same as the ordinary income tax rate)

Since your tax rates may differ depending on your income bracket, it is wise to consult your CPA for tax advice.

Some companies will allow RSU holders to tender or sell a certain number of shares to cover associated taxes, and so prevent holders from tapping into their personal funds.

Electing to Exercise a Section 83(b)

As the holder of RSUs, you may exercise a Section 83(b), allowing you to use the grant date share price, and not the vesting date share price to determine your taxable amounts. You may file a Section 83(b) election if your RSUs have a 5+ year vesting schedule.

This will require you to pay tax before vesting, but will ultimately minimize your liability if the stock is valued lower.

Your benefit is seen through the tax rate. Should you elect to report the stock’s full market value on the grant date, you will be exposed to capital gains tax on any appreciation of the stock that occurs during vesting. This is useful if you plan to hold the stock for a long time.

How to Report RSU Tax on Your Tax Return

As a form of employee compensation, restricted stock is routinely reported on your W-2. In most instances, employers withhold taxes on behalf of their employees, and these go against what you owe when you do your taxes.

If your employer does not withhold tax on your RSUs, you’ll be responsible for paying estimated taxes on their value. As with other estimated taxes, the IRS requires that you send quarterly payments for the estimated amount of tax you’ll be liable for at the end of the year.

To explore the intricacies of RSU Vesting, Payouts, and Tax Implications, click here for our Easy Guide.

Why Hitch Your Wagon to WestStar?

We understand our Aviator clients’ unique financial planning needs, whether they’re just starting out in their career or counting down to retirement.  Given the complexities of their compensation package, it makes sense for them to work with financial professionals who truly understand the ins and outs of equity compensation, especially the IRS rules governing stock options, restricted stock, and other forms of equity-based compensation.

To make sure you’re equipped with the knowledge, advice and guidance you need to pursue your future with confidence and clarity, 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