Understanding RSU: Compensation, Taxation, and Managing Restricted Stock Units
Restricted Stock Units (RSUs) are a popular form of equity compensation companies offer, especially in industries like technology and finance. RSUs provide employees with company shares after a specified period, called the vesting period. Unlike stock options, RSUs don’t require an upfront purchase, making them an attractive compensation tool. In this article, we will learn how RSUs work, their taxation, advantages, and how to manage them effectively.
How Does RSU Work?
RSUs are promises by a company to give its employees shares of stock after a predetermined period or when certain performance goals are met. Unlike stock options, which give employees the right to purchase shares at a specified price, RSUs don’t require any upfront payment. Employees receive the actual shares once the vesting conditions are fulfilled.
Vesting Schedule
The vesting schedule is a key component of RSUs. Companies set a specific time frame during which employees gradually earn their shares. For instance, an employee might be granted 1,000 RSUs with a four-year vesting schedule. This means 250 shares vest each year. In many cases, if the employee leaves the company before the vesting period ends, they forfeit their unvested shares, ensuring a longer commitment to the company.
Performance-Based Vesting
Occasionally, RSUs may vest based on company performance rather than time. For example, an employee might receive RSUs that only vest if the company hits specific financial goals, such as a particular revenue target or stock price. This type of vesting encourages employees to work towards the company’s success, aligning their efforts with company goals.
No Action Required to Receive Shares
Once the RSUs vest, the employee automatically receives the shares, unlike stock options, where employees must choose to exercise their right to buy shares. With RSUs, employees simply wait until the vesting period is complete, at which point they receive the stock without needing to purchase it.
Restricted Period
The period before RSUs vest is called the “restricted” period. During this time, employees don’t own the shares and cannot sell or transfer them. Once the shares vest, they are no longer restricted, and employees can sell them or hold on to them depending on their personal financial goals.
Sell or Hold Decision
After vesting, employees must choose between selling their shares or holding onto them. Holding could result in substantial capital gains if they expect the stock price to increase. However, a stock price decline would reduce their shares’ value. This decision depends on market conditions and individual financial goals.
RSUs vs. Stock Options
Although both RSUs and stock options are forms of equity compensation, they differ in several ways.
Upfront Purchase vs. Guaranteed Shares
The main difference between RSUs and stock options is that RSUs don’t require an upfront purchase. With stock options, employees can purchase shares at a specific “strike price.” If the company’s stock price rises above the strike price, the employee can buy shares at a lower cost and profit from the difference. However, if the stock price falls below the strike price, the employee’s stock options could be worthless. RSUs, on the other hand, guarantee value once the shares vest, as they are awarded at the stock’s current market price.
Risk of Stock Options Going Underwater
Stock options risk becoming “underwater” if the company’s stock price drops below the strike price. In such cases, the employee would lose the opportunity to profit from the options. RSUs don’t have this risk because employees are awarded the stock outright once the vesting period is complete, regardless of the stock’s performance before vesting.
Differences in Taxation
Stock options are typically taxed when exercised, meaning the employee has to pay tax on the difference between the stock’s market price and the strike price. RSUs, by contrast, are taxed as ordinary income at the time of vesting, based on the fair market value of the shares. We’ll explore this taxation aspect in more detail later.
Common Uses of RSUs and Stock Options
Stock options are often used by early-stage startups or companies that are not publicly traded, allowing employees to buy shares at a low price before the company grows. RSUs are more commonly offered by larger, publicly traded companies as part of broader compensation packages.
Taxation of RSUs
One of the most critical aspects of RSUs is their taxation, which can significantly impact an employee’s overall compensation. RSUs are taxed as ordinary income when they vest, and the value of the shares is included in the employee’s taxable income.
Tax at Vesting
When RSUs vest, the value of the shares on the vesting date is considered taxable income. This means that the company usually withholds some shares to cover the tax liability, and employees are taxed at their regular income tax rate. For example, if an employee’s RSUs vest at a value of £10,000, that amount is added to their annual income, and taxes are calculated based on their tax bracket.
Sell-to-Cover Tax Strategy
Companies often withhold a portion of the vested shares to cover the employee’s tax liability. This is known as a “sell-to-cover” strategy. For instance, if an employee is granted 1,000 RSUs, the company may withhold 200 shares to pay for taxes, leaving the employee with 800 shares. This ensures that employees don’t have to pay taxes out-of-pocket when their RSUs vest.
Capital Gains Tax
If an employee chooses to hold onto their vested RSUs rather than selling them immediately, they may be subject to capital gains tax when they sell the shares in the future. The capital gains tax is calculated based on the difference between the value of the shares at vesting and the value when the employee sells them. For example, if the shares are worth £10 at vesting and the employee sells them for £15 a year later, the £5 increase is subject to capital gains tax.
Additional Taxes
In addition to income tax, RSUs are subject to other taxes, such as Social Security and Medicare. Depending on where they live and work, employees may also be required to pay state or local taxes. The tax burden on RSUs can be substantial for high-income earners, so it’s important to plan and work with a financial advisor to minimise the impact.
Advantages of RSUs
RSUs offer several advantages that make them a valuable compensation for both employees and companies.
Guaranteed Value
One of the biggest advantages of RSUs is that they guarantee value at vesting. Unlike stock options, which can become worthless if the stock price falls, RSUs always have value because they are granted at the market price when they vest. This makes them a less risky form of equity compensation for employees.
No Upfront Costs
RSUs don’t require employees to purchase shares upfront, which can be a major financial advantage. With stock options, employees must pay the strike price to buy the shares, which can be expensive if the stock price has risen significantly. RSUs eliminate this need for upfront payment, making them more accessible for employees.
Employee Retention
RSUs are an effective tool for retaining employees, providing a strong incentive to stay with the company. Since RSUs vest over time, employees are motivated to stay until they receive their full share of the stock. This helps companies keep valuable talent and ensures that employees are aligned with the company’s long-term success.
Low Administrative Costs
RSUs are relatively easy for companies to administer compared to stock options. Since the shares are not issued until they vest, companies don’t need to track or manage them in advance, reducing administrative costs. Additionally, RSUs allow companies to avoid diluting their stock when stock options are exercised.
Risks and Disadvantages of RSU
Despite their advantages, RSUs carry some risks and disadvantages:
No Dividends or Voting Rights Before Vesting
Until RSUs vest, employees do not have any ownership rights over the shares, which means they cannot vote on company matters or receive dividends. However, some companies may offer dividend equivalents, payments made to employees to offset the lack of dividend income.
Forfeiture Risk
Employees who leave the company before their RSUs vest forfeit the unvested shares. This can be a significant disadvantage for employees considering changing jobs before their vesting period. In some cases, companies may have provisions allowing partial vesting if the employee leaves due to certain circumstances, such as retirement or disability.
Tax Burden at Vesting
RSUs are taxed as income at vesting, which can create a significant tax burden for employees. Depending on the value of the shares at vesting, employees may be in a higher tax bracket, leading to a larger tax bill. Employees need to plan for this tax liability and consider strategies, such as selling some shares, to cover the taxes.
Stock Price Volatility
While RSUs provide guaranteed value at vesting, the stock price can fluctuate after vesting, which can impact the overall value of the shares. If the stock price drops significantly after vesting, employees could lose some compensation. Conversely, if the stock price rises, the employee stands to gain significantly, but this is never guaranteed. The value of the RSUs at vesting may not hold up in the future, meaning that the stock price could fall after the shares have vested. This volatility can be incredibly impactful if employees rely heavily on RSUs for their compensation.
Concentration Risk
Employees who receive a large portion of their compensation through RSUs may face concentration risk. This occurs when a significant amount of their wealth is tied up in the company’s stock. If the company underperforms or its stock price falls, employees could see a substantial decrease in their overall financial position. For this reason, employees need to diversify their portfolios and not rely too heavily on a single company’s stock.
Managing RSUs Effectively
Managing RSUs requires a strategic approach to maximise their benefits and minimise risks. Here are a few ways employees can manage their RSUs effectively:
Tax Planning
As RSUs are taxed as ordinary income at vesting, planning for the tax liability in advance is essential. Employees should work with a tax advisor to estimate their tax bill and ensure they have enough funds or shares to cover it. In some cases, employees may sell a portion of their shares immediately upon vesting to cover taxes and avoid any surprises come tax season.
Sell-to-Cover Strategy
One common tax burden management approach is the sell-to-cover strategy, in which employees sell enough shares to cover their tax liability. For instance, an employee receiving 1,000 shares upon vesting might sell 200 to cover taxes, leaving them with 800 shares. This strategy allows employees to cover their tax obligations without paying out-of-pocket.
Holding vs. Selling Shares
Once RSUs vest, employees must decide whether to hold or sell the shares. Holding the shares can lead to capital gains if the stock price rises, but it also comes with the risk that the stock price could fall. When making this decision, employees should consider their overall financial goals, risk tolerance, and the company’s performance. Diversifying their portfolio by selling a portion of the shares and investing in other assets can help mitigate the risks of holding too much company stock.
Diversification
Employees should avoid having too much of their wealth tied up in the company’s stock, as this exposes them to the risk of the company underperforming. Employees can reduce their concentration risk and protect their overall financial position by selling a portion of their RSUs and investing in a mix of stocks, bonds, and other assets.
Working with a Financial Advisor
Given the complexities of managing RSUs, it’s often a good idea to work with a financial advisor who can help create a strategy tailored to the employee’s needs. A financial advisor can provide guidance on tax planning, portfolio diversification, and long-term financial goals, helping employees make informed decisions about their RSUs.
Examples of RSUs
Madeline’s RSU Agreement
Madeline is offered 1,000 RSUs as part of her compensation package. The RSUs vest over four years, with 25% vesting each year. In her first year with the company, 250 shares vest, and the stock price is £20 per share, making her RSUs worth £5,000. However, because RSUs are taxed as ordinary income, Madeline faces a tax liability of £5,000. Her company sells 50 shares to cover the taxes, leaving her with 200 shares. Over the next three years, her remaining 750 shares vest, and she continues to manage her tax liabilities similarly.
RSUs at IPO
Another example involves RSUs at a company that goes public. Let’s say an employee at a pre-IPO company is granted 5,000 RSUs with a double-trigger vesting condition, meaning the RSUs only vest after the company goes public and the employee meets the time-based requirement. When the company goes public at £50 per share, the employee’s RSUs vest, creating a tax liability of £250,000 (5,000 shares x £50). The employee sells 1,000 shares to cover the taxes and receives the remaining 4,000 shares. The employee then needs to decide whether to hold or sell the shares based on their financial goals and the company’s performance.
FAQs
What is RSU Salary?
RSU salary refers to compensation in the form of Restricted Stock Units (RSUs), where an employee receives company shares as part of their total salary package. The employee does not immediately own these shares and typically vest over time. RSUs are considered part of an employee’s overall salary but are taxed as income when the shares vest. Unlike cash salary, the value of RSUs can fluctuate with the company’s stock price, providing potential for capital gains but also some risks.
How Does the RSU Work?
RSUs are shares of company stock granted to employees. These shares remain restricted until certain conditions, such as a time-based vesting period or performance milestones, are met. Once the vesting conditions are fulfilled, the employee gains ownership of the shares and can sell them. At vesting, RSUs are taxed as ordinary income based on the market value of the shares at that time. The employee can decide to hold the shares for potential capital gains or sell them immediately.
Is it Better to Take RSU or Stock Options?
The choice between RSUs and stock options depends on several factors, including the company’s stock price trajectory and the employee’s risk tolerance. RSUs are generally less risky because they guarantee value at vesting, regardless of stock price fluctuations. On the other hand, stock options can offer greater potential rewards but come with the risk of being “underwater” if the stock price falls below the strike price. RSUs are usually better for employees seeking stability, while stock options are preferable for those willing to take on more risk in exchange for potentially higher returns.
Does 1 RSU Equal One Stock?
Yes, generally, 1 RSU equals one share of stock once the RSU vests. RSUs represent a promise to deliver shares in the future. After the vesting period or performance conditions are met, the employee receives actual shares of the company’s stock on a one-to-one basis (i.e., 1 RSU converts into one share of stock).
Can I Sell My RSU?
You can sell your RSUs only after they have vested. Once RSUs vest, they become actual shares of the company stock, and at that point, you can sell them just like any other stock. However, some companies may have restrictions or blackout periods during which employees cannot sell their shares, so it’s essential to understand the company’s policies on selling vested RSUs.
