Ready For Retirement
Ready For Retirement
Restricted Stock Units: The Basics of RSUs and How to Use Them
ames responds to a question from Chris regarding restricted stock units (RSUs) and how to avoid costly mistakes when managing them. He explores whether it’s wise to hold onto company stock or diversify for a safer financial future. He breaks down how RSUs work, from vesting schedules to the tax implications of receiving stock as part of your compensation package. He also explains the critical considerations you should make when deciding whether to hold or sell vested shares and how this decision fits into your broader investment strategy.
Questions answered:
Should I hold onto or sell my vested RSUs?
What are the tax implications of RSUs, and how can I avoid mistakes?
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Timestamps:
0:00 - How RSUs work
4:24 - Like a cash bonus
7:17 - Question your performance assumptions
12:25 - How RSUs are taxed and paid
15:14 - Default withholding rate and wash sale rules
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In today's episode of Ready for Retirement, we're going to go over what restricted stock units are, as well as what you need to be doing and what you must know in order to avoid what could be some costly mistakes with your RSUs. This is another episode of Ready for Retirement. I'm your host, James Canole, and I'm here to teach you how to get the most out of life with your money. And now on to the episode. Today's episode comes from a listener question. This listener's name is Chris. Chris says the following Next year I'm investing in a large company restricted stock unit, or RSU. The company is doing very well, but I'm wondering how I should handle the individual stock. Do I keep 100% and expect to beat average market returns, or should I sell some or all and reinvest to better balance and de-risk my portfolio? Thank you, Chris. Well, pretty straightforward question here, but one with enormous implications whether you're doing it correctly or incorrectly or anything in between. It is really important to know that, if you do have equity compensation, how should you treat those grants? How should you treat stock as it vests? Now, there are multiple different kinds of equity compensation. You can have non-qualified stock options. You can have incentive stock options. You can have restricted stock units, you can have performance stock units, you can have employee stock purchase plans. So every single one of those has a lot of nuances that are important to understand with regards to your planning. But today, specifically, we're going to be talking about RSUs, which stands for restricted stock units.
Speaker 1:Let's use an example here to start out of how do RSUs actually work. For this example, let's use someone who works at Google and let's assume that at Google they have restricted stock units. They have RSUs as part of their compensation package. Let's assume that this individual let's call this person Chris. Now, Chris is the name of the person who submitted this question. I have no idea what company he works at, what the amount of RSUs is, so this is just hypothetical. But let's assume Chris signs on at Google and as part of his comp package he gets $100,000 of RSUs. Those RSUs, let's assume, vest over the next four years. So, yes, if Chris stays at Google for the next four years, he gets all those restricted stock units, but those aren't actually worth anything to him today, Because if Chris were to leave Google tomorrow or get terminated next week, those become worthless. They don't actually have any value to you until they vest and once they vest, you become the actual owner of those shares. So let's assume in this example that 25% of this restricted stock vests every single year. So in this example, you do not pay any taxes when you receive that grant, the $100,000 of RSU grants that you receive not taxable when you receive it. When you do pay taxes is when that vests. And because typically RSUs are vesting over time some do have a cliff vest, but oftentimes RSUs will vest over a period of years You're only paying taxes as those shares vest.
Speaker 1:So let's take a look at an example. Chris goes to Google. He gets $100,000 in RSUs Over the next 12 months. Google stock increases by 20%. So now those RSUs, the unvested RSUs, are worth $120,000 because of the price increase.
Speaker 1:Let's also assume that after one year, exactly one fourth of those RSUs vest. Well, one fourth of $120,000, that's $30,000. So what happens is $30,000 of that total now actually belongs to Chris. It vests. He can do with it what he wants. The remaining $90,000 still remains unvested. That will continue to vest over the next three years, but it's only that $30,000 that he's paying taxes on today.
Speaker 1:So whatever the amount that's vesting is, that's what you owe taxes on and you will pay taxes at ordinary income rates. This is a common question. It's stock. I've been in the company for a year or more. Does that mean that I get long-term capital gain status on this? Unfortunately, no. When those RSUs vest, they are taxed at ordinary income rates. Ordinary income rates are higher than long-term capital gain rates. So in this example, Chris would be paying taxes on $30,000, the same way he would be if he received a bonus of $30,000. So that's the basic way he would be if he received a bonus of $30,000. So that's the basic way that RSEs work.
Speaker 1:Now, oftentimes you might be getting new grants every single year. So as these grants start to vest, you can see that snowballs a little bit. In years three and four and five you are getting the vested stock from your initial grant. Plus, if you continue to receive that stock grant on an ongoing basis, you're getting those shares as they vest. So this is how equity compensation can become pretty serious in terms of the amount of your compensation it receives assuming, of course, you're working at a company that's performing well. But that's how restricted stock works.
Speaker 1:Now let's talk about what should you do with it, how do you make the most of it and, equally important, how do you avoid some major mistakes when it comes to your restricted stock units? The first thing that I recommend people do when they receive restricted stock is to change the way they think about it. So if I go back to the question, Chris says the company is doing very well. Do I keep 100% and expect to beat average market returns? When you own something already, especially if it's something that's doing really well, it's pretty hard to give that up. It's pretty hard to make the decision to sell that.
Speaker 1:Let's change the way we think about this. If we assume the example we used earlier of $30,000 vesting this year and assume this is Chris that's receiving that, I would ask Chris to imagine he received a $30,000 cash bonus. You receive that cash bonus. Taxes are taken out. Let's assume maybe there's $20,000 after taxes. What do you do with that money? If the answer that Chris gives is I would turn around and purchase Google stock, Well then great. Keep the shares that just vested in Google stock, because that's exactly what you're doing. But if the answer is I would invest in a more diversified portfolio, I would pay down debt, I would take the family on a trip. If the answer is literally anything else besides purchase Google stock as his response, then I would not recommend that you continue to hold on to whatever shares just vested and just so happen to be in Google stock.
Speaker 1:The reason that I would encourage this way of thinking about RSUs that are investing is because there's zero tax benefit to keeping those shares. If there was some special tax treatment or some special tax benefit to keeping those shares in restricted stock, then that might be a different story. That might be a reason to keep those shares versus doing something different with them. But there's no benefit. You would be taxed the same exact amount if you received a $30,000 bonus in cash versus receiving $30,000 of restricted stock. That's vesting. So, because there's no difference, you have to think of whatever RSUs are vesting. Think of that as a cash bonus and if you keep your money in the company stock, it's the exact same thing as receiving that bonus and using it to purchase shares of your company stock. It's the exact same thing as receiving that bonus and using it to purchase shares of your company stock. If that's what you would do with your bonus, then keep the RSU shares as is. If that's not what you would do with your bonus, then seriously consider selling those shares and using it to do what you would have done with that bonus.
Speaker 1:Many of you who are listening you might be subject to some restricted trading windows. So if you are an executive at a company, if there's some other things going on, you might not always be able to sell your stock whenever you want to. There might be blackout dates or some type of restricted window from when you're not allowed to actually sell company shares. So I fully get that. But for those of you that can, and even those of you that do have blackout dates or restricted trading times, still try to look for a way of what should we be doing ahead of our stock vests to prepare for what to do with that money when it actually does vest. So that's the first thing that I recommend to people when they have RSEs that are vesting. Step number one is change the way you think about it. Think about it as a cash bonus. What would you do with that cash bonus? The second thing I would think about no-transcript past is going to continue happening, going forward.
Speaker 1:All of us logically say that, but almost all of us emotionally, when it comes to our money, have a very difficult time not doing something, not putting our money in the things that have performed best over the past few years. But if investing were as easy as just purchasing whatever stocks had performed the best recently, all of us would be much, much wealthier. The problem is, none of us know exactly what's going to outperform next and we can look at what's done well recently. That's not always a great indicator of what's to come. Let's use a stock that's been in the headlines quite a bit over the last number of years to illustrate this Tesla. So since the beginning of 2018, Tesla stock is up over 45% average annualized return per year.
Speaker 1:If you have an investment that's growing by 45% per year, and if it does that for six and a half years, which is about the time period from beginning of 2018 until the time I'm recording this podcast, your investment has increased in value by 13 times. So you put in a thousand dollars you know how $13,000. You put in a hundred thousand dollars, you now have $1.3 million. That's an enormous return over six and a half years. For context, the S and P 500, which has also done really well over that time period, has averaged about 14% per year. So, 45% per year over this time period for Tesla, 14% per year over this time period for the S&P 500, both are incredible returns.
Speaker 1:But here's the thing. Let's assume that at the end of each year, you chose one of those to invest in, but you chose the one that had performed best recently. So, somewhat to Chris's point here hey, the company's performing well. I don't know if he's talking about over the last year, the last five years, last 10 years, last 20 years, but let's look at this. If you just chose S&P 500 or Tesla, based upon which had performed best the previous year, let's start by going back to 2018. 2018, Tesla was up about 7%. The S&P 500 was down about 4%, so Tesla outperformed by 11% in that year. So, end of 2018, you see that you're saying great, I'm going to purchase Tesla and you own Tesla now for 2019.
Speaker 1:Well, 2019, Tesla did pretty well. It was up over 25%, but the S&P was up over 31%, so Tesla underperformed the S&P by about 6% that year. So you sell Tesla and you buy the S&P 500 because, again, we're going to purchase what had performed best recently, so underperformed by 6%, even though both of them performed well. As a side note, even though Tesla ended up over 25% for that year. Had you gone, in the first five months of the year Tesla was down about 45%. So I would argue not enough people actually accomplished or achieved that 25% return it had over the course of 2019, because the first five months of the year is down 45%. When something's down 45%, it's tempting for a lot of people to sell that investment and then they miss out on the recovery. But I digress. S&p 500 outperformed, so people sell Tesla, they buy S&P 500.
Speaker 1:Then 2020 comes around. The S&P 500 is up 18%, pretty solid, but Tesla is up 743%. It blows everything out of the water. Enormous return. So at the end of 2020, people purchased Tesla. In 2021, Tesla actually outperforms again. So second year in the row it's up 50% compared to the S&P 500 being up 29%. So two years in a row people are out of their S&P 500 investment. They're pouring into Tesla.
Speaker 1:Then 2022 hits. The S&P 500 is down 18%. That's pretty painful, but if you think being down 18% is painful, Tesla is down 65% in 2022. That's an excruciating experience that not too many people can take and continue to remain fully invested. It loses almost two-thirds of its value in 12 short months.
Speaker 1:So at the end of 2022, let's assume that you're chasing performance. You see S&P 500 outperformed, even though it's still negative, by quite a significant margin. You move all your money back into S&P 500. Well then, 2023 comes along. S&p 500 does great. It's up 26%, but Tesla's up over 102%. You move your money back into Tesla in 2024, so far this year, Tesla is underperforming the S&P 500 by about 17%.
Speaker 1:So that has nothing to do with restricted stock in general and the tax consequences and how it works. What it does have to do with is how this should fit into your overall investment strategy, where, if you just look at what's returned the best recently over the last 12 months, three years, even five years, even you might miss out on what's going to perform best over the next 12 months, three months, five months. So take the approach of what would you do if this was cash? And if this was cash, would you go purchase your company stock because you expect an out performance? Maybe, maybe not. You have to look at the grand scheme of things. You have to look at the grand scheme of things. You have to look at your plan. You have to look at your goals and if your goal isn't just accumulate as much stock as possible, but invest in a more diversified way, targeting better long-term growth potential. That's what I typically recommend people do in this case. So those are a couple of points directly related to Chris's question.
Speaker 1:Now I want to go over four things that you need to know to ensure that you're making the most of your RSUs and, like I said earlier, equally important you're not making a major mistake that ends up costing you quite significantly. So, first thing that I want to go over how are RSUs taxed. I summarized some of it. Which is the day the RSUs vest. The value of the vested shares is taxed, like it would be if you earned a bonus. It's taxed to ordinary income rates, which means federal taxes, state tax, depending on the state that you live in, plus FICA taxes, so payroll taxes. Well, those are taxes.
Speaker 1:If you purchase a stock that day, you now enter capital gains taxes. If you hold an investment for over a year, you pay long-term capital gains tax. If you hold an investment for one year or less, you're paying taxes at short-term capital gain rates, which is the same thing as ordinary income rates. So the day that money vests, the day that stock vests, you pay ordinary income taxes. Then you have a new tax rate going forward, which is your capital gains rate. So any growth or decline going forward after the date of vesting. You're going to pay short-term capital gains If you hold that stock for a year or less. You're going to pay long-term capital gains taxes If you hold that stock for a year or less. You can pay long-term capital gains taxes if you hold that stock for a year or more.
Speaker 1:The next thing then is how do you actually pay these taxes? Because there's a few different options. The first is sell to cover. Sell to cover is probably the most common. Sell to cover says if you have $30,000 of stock vesting and your tax rate, let's say, is 33% combined, then you have a third of that, or $9,000, where the company that's administering this plan will sell $9,000 worth of stock to pay your tax bill, and then you're left with $21,000 of stock leftover. So you guys $30,000 vested but you owe taxes on that. So what you're left with is the amount after taxes are withheld, and that's called sell to cover, when shares are automatically sold so that tax withholding payment can be made.
Speaker 1:You also have same-day sale. Now same-day sale sometimes. I recommend people just set it up this way If you're going to apply the approach that as soon as your stock vests, you're going to sell it because you're going to treat that as a cash bonus, as opposed to just holding the shares. Same-day sale means as soon as that stock vests, it's all being sold. You then have cash that can be transferred to your account and you can do whatever you want with that cash. Now, obviously it's part of the same day sale. You don't avoid taxes if you sell on the same day. You still pay those ordinary income tax rates. So even if you're selling right away, some is still withheld to pay taxes and you are left over with the remaining cash balance. And the final thing that you can do to pay taxes on this is you can just make a cash payment. If $30,000 vests and you know that your tax payment is going to be $9,000, you can come up with the cash to pay that taxes while still leaving your $30,000 intact. So if you did take the approach, if you do want to keep money in company stock you don't want to sell any piece of it you do have the option of coming up with the cash to pay the taxes and keeping all the shares intact in whatever your company stock is.
Speaker 1:Now this leads to the next point that people really need to know about RSUs, which is what's the default withholding rate. Typically, the default withholding rate is going to be 22% at the federal level. Now that might be fine if you're in the 22% marginal federal tax bracket. Where that's not fine is for many people who do have stock compensation or equity compensation. Many times they are in much higher tax brackets. So if you're in a 35% tax bracket but your default withholding is 22%, what that means is if you have $100,000 of RSU's vest, $22,000 will be taken out to pay your federal tax bill, but your actual federal tax bill on that is $35,000. What does that lead to? It leads to nasty surprises come tax time when you learn that you owe that $13,000 delta plus potentially have some under withholding penalties. So this should be a big part of tax planning for anyone that has equity compensation and specifically RSUs.
Speaker 1:If you have RSUs, one thing that you should know is what's your overall tax situation look like, as well as what marginal tax bracket do you believe that you're in that way, when this RSU is vast, you can understand what's the default amount that's being withheld in taxes and you should be able to adjust that, but at a minimum. If not enough is being withheld in taxes, then can you do planning on your own or with your advisor to say this additional amount needs to be freed up in cash so that we can pay that into taxes, so we don't have any bad surprises come tax time and so that we avoid underpayment penalties by not withholding enough throughout the year. And then the final thing I want to point out today with RSUs is the wash sale rule. If you are receiving RSUs, the day that those RSUs vest is treated as a purchase for wash sale rules. Why does that matter?
Speaker 1:Well, if you own your company stock, let's go back to owning Google. Maybe you own a lot of Google in a brokerage account and the value of Google stock declined and you say you know what this actually presents a tax loss, harvest and opportunity. I'm going to sell Google stock, I'm going to lock in the loss and then I'm later going to repurchase Google stock so that I don't lose my exposure to it, assuming you want to keep it as part of your portfolio. Well, that might be great, and maybe you have your brokerage account elsewhere where you're doing that. But let's look at an example of how that could go wrong. Let's assume that 15 days ago, you sold your Google shares. That's part of the days ago. Well, today, your Google stock vests. Well, what that vesting does even though you're not in your brokerage account actively making purchase orders that vest is going to be treated as a purchase, which then disallows the losses that you received when you sold your Google shares. So this is something that you need to be really careful of is when you do have restricted stock, when you do have other types of equity compensation, be very careful about what you're doing in your outside accounts and your brokerage account, because those vests count as a purchase. And if you've sold some Google shares, even if it wasn't something that you thought that you were going to violate wash sale rules on because you kept that brokerage account separate, all this has to be looked at holistically. So really, make sure that you're looking at that as part of your overall strategy. So that's what we have for today's episode on restricted stock units, or RSUs. Chris, thank you very much for submitting that question, allowing us to use you as an example, albeit a hypothetical example, as we go through this For those of you listening.
Speaker 1:Thank you for listening. If you're enjoying this, please make sure that you're subscribed to our YouTube channel. Please make sure you've left a review. If you're listening on Apple Podcasts or Spotify, and if you're enjoying this and you know someone that might benefit from it, please don't hesitate to share an episode with them, Whether it's a coworker, a family member, a neighbor, someone that you're hoping will get good information so they can be best prepared for their retirement. But again, thank you for listening, Really appreciate y'all taking the time to do so and I'll see you all next time.
Speaker 1:Hey everyone, it's me again for the disclaimer, Please be smart about this. Before doing anything, please be sure to consult with your tax planner or financial planner. Nothing in this podcast should be construed as investment, tax, legal or other financial advice. It is for informational purposes only. Thank you for listening to another episode of the Ready for Retirement podcast. If you want to see how Root Financial can help you implement the techniques I discussed in this podcast, then go to rootfinancialpartnerscom and click start here, where you can schedule a call with one of our advisors. We work with clients all over the country and we love the opportunity to speak with you about your goals and how we might be able to help. And please remember nothing we discuss in this podcast is intended to serve as advice. You should always consult a financial, legal or tax professional who's familiar with your unique circumstances before making any financial decisions.
