Must-Knows About Restricted Stock

No matter the type, employer stock is fraught with contradictions.

On the one hand, it’s a key source of wealth for many households. It's also typically issued as a bonus, above and beyond regular compensation, so employees who receive it might be inclined to think of it as "gravy," or mad money.

On the other hand, employer stock can introduce risk and complexity into an individual's financial plan. After all, employees have a lot riding on their companies' wherewithal even before employer stock enters the picture, because that's where they earn their paychecks. By owning company stock, employees effectively double down on their bet on the financial health of their firms. Moreover, company stock can introduce tax headaches, especially for people who aren't well versed in the tax treatment of these assets.

Over the next three weeks, I’ll be delving into three key types of employer stock. This week's installment will discuss restricted stock units, or RSUs; next week, stock options; and the week after that, employee stock option plans, or ESOPs.

RSU Basics

Like other types of employer stock, restricted stock is often issued by employers as an incentive for key employees to stick around. That's why restricted stock units don't typically carry any value at the time they're issued but rather at some future date, when the shares vest. Vesting schedules for RSUs vary, but a common configuration is for an RSU grant to vest over a period of four years, with 25% of the granted shares vesting per year. Alternatively, the vesting might be conditioned upon the employee or his/her business unit hitting certain performance targets. The latter type of arrangement is more common for executives than it is for rank-and-file employees, though.

Tax Treatment

The tax treatment of RSUs is pretty intuitive. No taxes are due when RSUs are issued to the employee. That's because the employee doesn't actually own shares of the stock at that time. Rather, the employee owns the shares when they've vested, and that's when taxes come into play.

To use a simple example, let’s say Sandra received 400 restricted stock units from her employer in 2020, vesting over the next four years. One hundred of the RSUs vested in 2021, when the stock price was $100. Sandra would see the $10,000 in income from her newly vested shares reflected on her W-2 form for this year, which would add to her wages/taxable income. She'd owe ordinary income tax on that amount. If she's in the 24% tax bracket, for example, that's an additional $2,400 in tax on her newly vested shares. (Some companies impose mandatory supplemental wage withholding to help cover the taxes on the newly vested shares; others do not.)

Her cost basis on that batch of shares is $10,000. If she sells within the first year of acquiring them, she'd owe ordinary income tax on any appreciation over the $10,000 level. If she waits a year and a day to sell, she'll be able to pay tax at the lower long-term capital gains tax rate. Back to the example: If she sells the shares that vested in 2021 in 2023, when the stock is trading at $150 and her position is worth $15,000, she'd owe long-term capital gains tax on the additional $5,000 in appreciation. She's not taxed again on the original $10,000 because she already paid that tax at the time of vesting.

Mitigating Company-Specific Risk

It almost always makes sense to hang on to RSUs until they vest, which underscores the importance of getting to know the vesting schedule for any RSUs that you receive. This is particularly important for frequent job-changers in sectors where RSU issuance is common, like technology. In that instance, the job-hopper will need to weigh the loss of unvested RSUs alongside the salary, bonus, and potential for equity participation in the new job.

A related question is whether it makes sense for RSU holders to hold the stock once it has vested or cut it loose. Of course, employees might like to own company stock because they believe they have an information advantage over other market participants. Yet that information edge might be illusory: David Blanchett, head of retirement research for QMA, found that companies whose employees have high aggregate allocations to company stock have tended to underperform those without, even when controlling for market capitalization, investment style, sector, and other factors.

Heavy weightings in a single stock--any stock--have the potential to make that portfolio more volatile than one that's more diffuse. Moreover, because company stock ownership is much heavier among larger-cap stocks than smaller ones, it's much more likely that the investor who owns a heavy stake in the company also owns additional shares in that same company through any mutual funds in the portfolio. Employees may also own employer stock in their retirement-plan accounts.

And then there are human-capital considerations: Employees who invest heavily in company stock have both their human capital and financial capital riding on the fortunes of a single company; difficulties at their employer could cause their stock shares to sink at the same time they suffer job loss or an income reduction.

Because of those types of risks, Blanchett concluded that the optimal allocation to employer stock is 0%. Zeroing out company-stock exposure might not be practical in each and every situation, but limiting stakes to 5% or 10% of a portfolio is a reasonable goal.

Mitigating the Tax Bill

Restricted stock and other forms of employer stock can get complicated, so employees who have large allocations to them would do well to seek advice from a tax or financial advisor. The conventional wisdom is to sell RSUs as soon as they vest, as doing so reduces the risk of having too much riding on one's employer. The employee will owe taxes, but if the sale occurs shortly after the vesting date, the bulk of the taxes due will be ordinary income tax on the vested amount; taxes on any additional capital appreciation will be a small piece of the tax bill.

At the same time, there are a few strategies to mitigate the tax bill associated with RSUs. Because the RSU vesting will likely jack up taxable income, the name of the game is to lower taxable income through other maneuvers.

After the RSUs vest and are sold, steering the proceeds of the sale into an IRA, making a full 401(k) contribution, or contributing to a health savings account are all ways to lower taxable income in the same year in which RSUs have vested. (Because your goal is to lower taxable income, funding Roth accounts will be less useful in this context than traditional tax-deferred accounts.) The strategy delivers on two fronts: The contributions reduce taxable income, while moving money out of employer stock and into something more diffuse within a tax-deferred account, such as an index fund or a target-date fund, helps reduce risk in the portfolio.

Charitable giving is another option for reducing the tax bill associated with RSUs. One particularly powerful maneuver involves gifting the shares directly to charity or to a donor-advised fund. If the shares have appreciated since vesting, these strategies negate any taxes due on the additional gains. Moreover, the donor can deduct the value of the contribution, assuming the donor's total itemized deductions--including the charitable contribution--exceed the standard deduction.