What is an RSU? Restricted Stock Units: Pros & Cons
By: AJ Ayers, CFP®
Summary:
Restricted stock units (RSUs) have exploded in popularity as a form of equity compensation, but do the perks outweigh the quirks? As more companies offer RSUs, it's essential that employers and employees understand the incentives and tradeoffs.
Understanding RSUs
Restricted Stock Units (RSUs) are a form of company stock that employees may receive as part of their equity compensation package.
RSUs differ from stock options, which give employees the right to purchase shares at a predetermined price. Instead, they represent a promise by the employer to award a certain number of shares of common stock to the employee at a future vesting date.
When a company grants RSUs to an employee, the shares are not immediately available. The employee receives the shares when they meet certain conditions, such as working for the company for a specified period, reaching specific performance milestones, or other goals the company sets. When the RSUs vest, the employee receives the shares and can either hold on to them or sell them on the open market.
RSUs offer several benefits to both employees and employers.
For employees, RSUs provide a way to share in the company's success, acting as a motivating factor for their continued dedication to the company. The vesting requirements also help retain top talent and align employee interests with those of the company's shareholders. RSUs may also provide some tax advantages, as the employee is typically only taxed when the shares are received, not when the RSUs are granted.
For employers, RSUs can be a more cost-effective form of compensation than stock options. The company is not required to sell shares at a lower price, and they can easily control the number of shares issued through RSU grants, making it easier to manage their equity structure.
Key Differences between RSUs and Stock Options
| Criteria | Restricted Stock Units (RSUs) | Stock Options |
|---|---|---|
| Granting Mechanism | Promise from the company to give an employee a certain number of stock shares. | Offer employees the right, but not the obligation, to purchase shares at a specified price (exercise price). |
| Upfront Cost | No money required upfront when granted. | No money required upfront, but need to pay the exercise price when exercising the option. |
| Taxation | Taxed on the value of the shares when they vest. The stock's fair market value is considered ordinary income. | Taxed when the option is exercised. The difference between the stock's market price and the exercise price is considered income. Some types (Incentive Stock Options) have more complex, but often more preferential tax treatment. |
| Timing of Ownership | Shares vest over a set time period (e.g., 3-4 years). Once vested, the employee owns the shares. | Employee has the right to exercise the option within a specified time period after grant (e.g., 5-10 years), and are also subject to vesting schedules. |
| Potential Value | Generally provides less potential value but more security. Employee receives the value of the stock at the time it vests. | Greater potential for gain if the stock price rises above the exercise price. Risk of becoming worthless if the stock price falls. |
Pros of RSUs
Firstly, RSUs align the interests of employees with those of the company's shareholders, motivating employees to work towards the company's long-term success. Naturally, when employees receive shares in the company, they become invested in the organization's performance, incentivizing them to ensure its growth and prosperity.
Retention and long-term focus are other advantages of RSUs. Typically, RSUs come with a vesting schedule, requiring employees to stay with the company for a specified duration before their shares vest. This structure reduces turnover and promotes a focus on the company's sustained success.
Cons of RSUs
First on our list, despite posing aforementioned advantages, is the long vesting periods that often accompany RSUs. These lengthy timelines may not provide enough incentive for employees to stay on board if they receive more alluring offers from rival companies.
Now let's discuss taxes – not exactly a thrilling topic, but an important one nonetheless. When RSUs vest, they become subject to taxation, and employees have little to no control over the timing of these tax payments.
How RSUs are Taxed
Let us break down each stage in the RSU lifecycle and its corresponding tax scenario.
At the grant stage, the employee is not subjected to any tax liability. We are in the clear during this phase, as an RSU grant is considered a promise, not a tangible asset quite yet.
As the RSUs vest, they then become taxable as ordinary income. The amount taxable is based on the stock's fair market value at the vesting date. At this stage, an employer needs to withhold federal, state, and local taxes along with employment taxes, such as Social Security and Medicare taxes.
Now, to cover these tax withholdings efficiently, the employer might withhold shares or offer a cash payment option.
Do keep in mind, though, that depending on your income, the withheld amount may not cover your entire tax obligation, so it's crucial to plan accordingly.
As for the final step, when you sell the shares obtained from RSUs, the difference between the sale price and the fair market value at vesting is subject to either short-term or long-term capital gains tax.
Bear in mind that long-term capital gains tax rates are generally lower than ordinary income tax rates, so if you can hold onto those shares for a longer period, you might save some money on taxes if they increase in value after vesting.
Clearly, dealing with RSUs and the various tax scenarios can be complex, which is where we come in to help. If you find yourself feeling overwhelmed, do consider seeking guidance from an accounting professional.
Strategies for Maximizing RSU Benefits
To help you make the most of your RSUs, we've put together some key strategies to ensure you're maximizing their value.
Firstly, it's essential to understand the details of your compensation package. Make sure you know the number of shares being offered, the grant date, and the graded vesting schedule. The value of the shares will likely fluctuate over time, so it's essential to keep yourself informed about the company's performance and any changes in the stock's value.
Managing your vested shares is another crucial aspect of maximizing RSU benefits.
Keep track of when your shares vest and develop a plan for what to do with them once they're no longer restricted. This could involve selling some shares to cover the tax withholding or holding onto them in hopes of future growth.
Diversifying your investments is always a wise move, and this applies to your RSUs as well. When your job offer includes equity compensation, it's easy to become overly focused on your company's stock.
However, maintaining a diversified portfolio will help protect you from potential downturns in the company's performance and ensure your financial stability.
Finally, don't underestimate the importance of staying informed. Keep up with company news, financial reports, and market trends to better understand your company's growth trajectory.
Navigating the world of RSUs can be a complex endeavor, filled with tax implications, vesting schedules, and strategic decisions about when to sell or hold your shares. While RSUs offer a compelling way to participate in your company's growth and secure your financial future, they also come with their own set of challenges and considerations.
If you're grappling with how to make the most of your RSUs, or if you're an employer looking to implement an effective equity-based compensation plan, professional guidance can make all the difference. Don't leave your financial future to chance. Contact a financial advisor at BKFi to help you unravel the complexities of RSUs and develop a strategy tailored to your unique needs.