Restricted stock units (RSUs) are a form of incentive compensation where a company gives an employee stock. Unlike an employee stock option, there is no need to pay for the shares.
RSUs are becoming much more common throughout corporate America. A 2021 survey from the National Association of Stock Plan Professionals and Deloitte shows that 86% of U.S. publicly traded companies grant RSUs, up from a mere 3% in 2000. By comparison, public companies offering employee stock options went from 100% to 47% during this period.
“The talent war has helped drive this trend toward RSUs, and we think that will continue,” says Joel Gerringer, the director of Stock Plan Administration at Charles Schwab . “Employees perceive RSUs as having more immediate and more guaranteed value than options.”
Let’s take a look at how RSUs work, tax rules and how advisors can help their clients.
One scenario: Let’s say an employer grants your client 4,000 RSUs when the stock price is $10. There is a four-year vesting schedule.
After the first year, your client receives 25% of the grant or 1,000 shares of the company. Suppose the stock price is now at $5. Your client’s 1,000 shares have a market value of $5,000. If this were an employee stock option, they would be worth nothing.
Before the shares vest for an RSU, the employer will usually not pay any dividends or provide voting rights.
Start-ups often grant what are known as double-trigger RSUs. “Double-trigger RSUs means that two events must occur prior to the shares being delivered and taxed,” said Richard Zajac, CPA and partner at Zajac Group. “First, the shares must vest. And second, there must be a liquidity event, sometimes an IPO. The double trigger prevents the RSUs of pre-IPO companies from being taxed when you may not be able to sell the shares to cover the tax bill.”
Tax strategies. Your client owes nothing at the time of the grant. They will instead have to pay taxes at ordinary rates when the RSU vests. “From a tax perspective, what that means is that you just got a $5,000 paycheck,” said Crystal Cox, CFP and senior vice president at Wealthspire Advisors.
For RSU amounts under $1 million, the withholding percentage is 22%. But if your client is in a higher bracket, they may face an unexpected tax bill when they file their returns. “In this case, you may want to pay quarterly estimated taxes so you don’t incur any underpayment penalties from the IRS,” said Matthew D. Saneholtz, president and senior wealth advisor at Tobias Financial Advisors.
If your client has a large tax bill from an RSU, they also may want to increase their deductions, say with retirement accounts, HSAs (Health Savings Accounts) or deferred compensation. With the latter, an employer delays the distribution of compensation, usually for retirement. This can mean playing lower taxes.
Another option is to increase charitable contributions with a donor-advised fund.
Something else in our RSU example: The $5,000 will become the employee’s cost basis in the stock. If the stock climbs to $7, your client will have a capital gain of $2,000. It will be a long-term gain—with a 20% maximum rate—if they hold on to the stock for over a year.
ISO strategies. It’s important to understand the vesting schedules for not only the RSUs, but other employee stock options—more companies offer both as RSUs have become more popular.
“If the client also has in-the-money incentive stock options, or ISOs, this year can be a very good year to exercise some of that,” said Beata Dragovics, founder of Freedom Trail Financial.
The reason is that ISOs are not subject to ordinary income-tax rates. Instead, the spread between the grant price and the current market price is a preference item for AMT. The Tax Cuts and JOBS Act of 2017 increased the AMT exemption to $73,600 for single filers and $114,600 for those married filing jointly for 2021. The phaseout of this does not start until income reaches $523,600 (single) and $1,047,200 (married).
So, for example, if your client exercises an ISO for a $25,000 gain, this amount may avoid AMT but also start the clock on the holding period. If they hold on to the share for over a year, the taxes will be at the favorable long-term rates.
Tom Taulli is a freelance writer, author, and former broker. He is also the author of the book, The Personal Finance Guide for Tech Professionals.