Restricted stock units are a great way for companies to add an incentive to employee compensation packages. If you are receiving restricted stock from your employer, understanding the various unfamiliar terms and tax consequences are important to maximizing their value.
All too often, employees don’t take the time to understand how vesting works or the tax implications of their restricted stock units. In this article, you’ll get a quick grounding in restricted stock to help you better understand, evaluate, and plan.
Restricted Stock Units and Stock Options Are Not the Same
It’s not uncommon to find restricted stock and stock options discussed within the same topic. Although often confused, these are not the same type of employee compensation. Trying to apply terminology from one to another can lead to lots of misunderstandings.
Restricted stock is simply stock (or the promise of stock) that a company will award to you at a future date. Stock options are the option to purchase said stock at a specific price at a future date. Restricted stock is taxed when it vests. Stock options need to be exercised and have different implications in regards to timing and tax.
Be sure when you see “restricted stock” that you are clear if it is referring to restricted stock and not stock options.
Restricted Stock and Vesting
Restricted stock may be granted as part of an employment package. At some later date after grant, you receive right the actual stock shares. Until then, you must wait before the stock is your property. This period of waiting is called vesting.
Vesting follows a schedule stated by the employer. It can be a graded schedule, in which certain amounts of shares are distributed to you over time. Or it can be a cliff schedule, which means all shares are vested at once on a future date.
- Graded Schedule – If you receive 1,000 RSUs as part of your restricted stock grant, they may be vested at 250 shares each year starting in the second year. The value of each set of vested shares is the market value at the time of vesting.
- Cliff Schedule – With this schedule, all shares become available after a certain number of years. For example, all 1,000 RSUs can vest after 3 years of service.
There are usually provisions in regard to vesting. If you become disabled, retire or die, RSUs may vest immediately. There can be provisions as to what happens when the company is bought out. What happens if you quit? It’s important to know all of these scenarios so that you can be prepared ahead of time with an informed decision.
Substantial Risk of Forfeiture
One of the main attractions for employers to issue restricted stock grants is that they incentivize employees to stay with the company for a number of years. If an employee wants the full value of their restricted stock, they must remain with the company until all shares have vested. This is known as a substantial risk of forfeiture. And during this time, the shares are not taxed.
For some employees, the substantial risk of forfeiture of restricted stock is based on performance. During each year of employment, the employee must hit certain performance metrics before stock shares vest. Additionally, employers might further restrict employees by requiring them to not only hit performance metrics but also remain at the company for a certain amount of time. For others, and commonly, the risk of forfeiture lapses with a passage of time.
An 83(b) election allows you to be taxed at the ordinary income rate on the stock share price at the time of grant rather than when restricted stock vests. This can present a tax advantage if shares at grant are lower than shares at the time of vesting. Any vested value above the grant price, assuming over a year later, will be taxed at the long-term capital gains rate.
Of course, there isn’t any way to know what the price of a stock will be years down the road. Forfeiture is still a risk, especially if your restricted stock is based on performance metrics rather than simply time at the company. For example, if you don’t hit performance metrics in the second year and are let go, you’ll forfeit any unvested restricted stock. What does this mean if you elected the 83(b)?
Basically, you will have paid taxes on a stock you will never own. This is a lose situation. You can’t claw back the taxes that have already paid.
There are many scenarios to work through when it comes to deciding on an 83(b) election. Also, since this decision needs to be made early on, usually within 30 days of the grant, you’ll need to be sure you’re making the right choice fairly quickly since you’ll be locking in a long-term impact that is irreversible. This is why discussing 83(b) election “for and against” scenarios with a financial professional is important.
Once shares have vested, many employees become confused about the tax implications. They’ll continue to hold the vested shares for a year, believing there is a long-term tax gain on the full value. This isn’t the case. A tax event occurs once the shares have vested. The result is that your vested shares are taxed as ordinary income.
If you hold the shares for an additional year, you can take advantage of long-term capital gains if the stock increases. But those gains will only be from your cost basis since vesting and not the full value of the vested shares.
Restricted stock is considered “supplemental” wages on your W-2. Depending on the full value of the vesting, the tax bill may be large. There are a few ways to pay your tax bill:
Share surrender – This method uses some of your RSUs to cover tax withholdings.
Direct payment – If you want to keep all of your shares, you can pay your taxes directly or have them withheld from your paycheck
If a tax deferral arrangement is available through your company, you can also choose to defer some taxes. You’ll still pay FICA and Medicare taxes at the time of vesting, but other taxes can be deferred. The arrangement must comply with deferred compensation rules of IRC Section 409A.
What Does This All Mean?
Keep in mind that on the vesting date, restrictions of your RSUs lapse and shares appear in a brokerage account that your company requires. Make sure the brokerage account is activated in your name.
As RSUs are vested through a schedule or at once, you should be planning and anticipate their financial impact. This can mean considerations to your savings, portfolio allocation, retirement and other areas of your financial life. To better understand the full scope vested shares may have, it’s best to speak with a financial professional.
None of the information in this document should be considered as tax advice. You should consult your tax advisor for information concerning your individual situation. Tax services are not offered through, or supervised by, The Lincoln Investment Companies.