If you work for a company that grants equity compensation, you are likely to receive either restricted stock or restricted stock units (RSUs).
Although they sound similar, there are some important differences worth understanding, as they concern your degree of control as well as the tax implications.
Restricted Stock vs Restricted Stock Units (RSUs)
While restricted stock and restricted stock units share similar nomenclature, there are several fundamental differences, namely when you are eligible to receive your shares, your ownership stake in the company, and the tax treatments.
Restricted stock grants the recipient company stock according to a specified vesting schedule, derived from the company or personal performance metrics or a particular timeline. Once the vesting requirements are reached, you receive an unrestricted right to the stock.
RSUs, on the other hand, represent an unsecured promise of a certain number of shares at the end of the vesting period.
The key difference, here, is the upfront “guarantee” of the stock. Recipients of restricted stock also obtain additional shareholder privileges like voting rights and the ability to receive dividends before the shares vest. RSUs don’t come with the same shareholder rights until they have fully vested.
Next, I’ll examine the tax implications of each.
How is restricted stock taxed?
Typically, restricted stock becomes taxable once it has vested. At that point, the fair market value of the stock will be taxable as ordinary income, reported through payroll with the appropriate taxes withheld.
The amount you’re taxed on comes from subtracting the exercise price and the fair market value (FMV) of the stock on the date that it’s fully vested. Should the shareholder hold the remaining stock and sell it at a later date, the difference between the sales price and FMV will be counted as either capital gains or losses.
Even though this is the typical tax treatment, both restricted stock and RSUs provide shareholders opportunities for electing different taxation than at the pre-determined schedule.
In the case of restricted stock, recipients have 30 days to file an 83(b) election with the IRS, which allows them to pay taxes at the date of grant, rather than at the date of the vest. This provides an opportunity to minimize compensation taxed as ordinary income (subject to social security and Medicare taxes), and instead shift all subsequent growth toward the more beneficial capital gains tax rates.
However, there are certain risks involved in this election. First, if you separate from your job before the stock vests, you have paid taxes on a value that you will never receive, with no means to recoup them.
Second, should the stock price drop significantly between the date of grant and the date of the vest, you have paid income taxes on a higher value than you received. In such a case, you could sell the shares and realize a capital loss, although it’s subject to a maximum annual deduction of $3,000.
Third, by paying taxes on shares that you potentially will not own for years, you’ve locked up your funds when you could’ve used them in other investments— including purchasing your company’s shares on the open market.
Finally, there is the risk of allocating too high a portion of your investment portfolio toward your company’s stocks, which could jeopardize your overall financial situation should the stock price drop significantly. Further, there is an additional lack of diversification since all or almost all of your compensation is tied to the same company.
While there are many risks, the potential upside to making an 83(b) election should also be considered. So before making the 83(b) election, it is wise to speak with both a financial planner and tax accountant.
How are RSUs taxed?
RSUs usually have much more straightforward tax considerations. With most plans, RSUs are taxed as ordinary income on the date of vesting. The amount reported is the fair market value of the stock on the day it vests, with income and social taxes (generally only Medicare) withheld as appropriate.
Restricted stock units aren’t eligible for an 83(b) election. However, they may—if a company’s plan allows it—offer an opportunity to defer receipt of the shares beyond the vesting date, whereby the taxation is similarly deferred.
This could be an important planning technique if you are near retirement and preparing to move to a lower or no tax state after retirement. By deferring receipt of the shares until after your move, and opting for annual payments in at least 10 installments, you can effectively change the character of the income from compensation to retirement income, whereby it will only be taxed in the location where you are resident upon receipt, instead of being sourced to the jurisdiction where you earned it.
For example, if you worked in California, where the highest marginal tax rate is 12.3%, you could save that amount by making this election and moving to Texas, which does not levy an income tax.
Again, this is a potentially complicated planning technique that should be first discussed with a financial planner and tax accountant before implementation (not to mention reviewing the corporate stock plan to confirm that it’s even an option).
What is the difference between Restricted Stock, RSUs, and stock options?
It’s essential to understand that neither restricted stock nor restricted stock units (RSUs) are stock options. Stock options grant a wide latitude with respect to determining when you can exercise them, which isn’t true for restricted stock or RSUs.
Instead, both are subject to pre-determined vesting schedules that indicate when you will receive them based on either time or performance metrics. Performance-based vesting schedules can encompass a wide array of benchmarks like achieving certain growth goals or share prices. While the exact determinations can vary widely, they will always be set forth in the company’s stock plan documents.
Time-based vesting schedules generally employ either a graded or cliff vesting schedule. For example, imagine that you have been granted 1,000 shares of either restricted stock or RSUs. The most common graded vesting schedule is ⅓ per year for three years, meaning that you will receive 33% of the shares on the anniversary date over each of the next three years. The most common cliff vesting schedule is 100% on the third anniversary of the grant date. Once the shares vest, they are automatically exercised, generating ordinary income.
Stock options, on the other hand, are generally similarly subject to such vesting schedules (either graded or cliff), but upon reaching the vesting date, employees are faced with the opportunity, not the obligation, to exercise the options and thereby purchase the company’s stock. This decision point provides a broader range of opportunities for controlling the timing and taxation of stock options than is available with either restricted stock or RSUs.
Build a plan that enhances your financial outlook
Equity-based compensation can create multiple financial planning opportunities that can be capitalized on to benefit your future goals. Understanding how your company’s unique plans operate puts you in a stronger position to maximize your after-tax income.
If you are interested in discussing what opportunities you may have with your own stock awards, please contact me.
