Your growing technology company may provide equity compensation.

Equity compensation is becoming more and more prevalent in today’s business marketplace, and in my most recent blog post, I gave an overview of some of its common forms including RSUs, ISOs and NQOs. In today’s post we’ll talk in more detail about Restricted Stock Units. RSUs give employees interest in company stock but have no immediate tangible value and cannot be sold until they vest. In practice, RSUs are an incentive for employees to stay with their employer at least through vesting and help the company do well so the shares increase in value.

How do RSUs work?

RSUs are often issued as part of a compensation or bonus in the form of company shares through a vesting plan. Vesting means the units become available. When RSUs vest, the unit is worth the fair market value, i.e., the share price, that day. RSU vesting periods can be monthly, quarterly or annually over several years (this is called a graded vesting schedule) but some do vest all at once (a cliff vesting schedule).

Let’s say, for example, you were granted 120 RSUs that vest over three years. This means that 40 RSUs would vest after one year of the grant date, another 40 after two years, and the final 40 after three years. When those first 40 vest, the amount of income you earn depends on the stock price that day. If the share price is $100, then those 40 units are worth $4000. That $4000 is earned income and will appear on your paystub.

At that point, the RSUs are now shares of stock. You can sell or hold on to the shares. If sold, that $4000 can be realized right away. If kept, you don’t receive any money. You might expect the stock to appreciate and want to hang on to them with a cost basis of $40 per share.

Should I sell or hold my RSU shares after they vest?

When it comes to selling or holding your shares, the two biggest factors to consider are your own short- and long-term personal financial goals and the potential tax implications.

This is part is important: Ask yourself about your own financial goals. Pay off debt? Buy a home? Grab your bestie and go on an African safari? On the other hand, you might want to take risks, too, if your other resources and financial plan can support holding onto the shares because you believe the price will increase.

Another consideration if you’re catching up on retirement savings, you might consider selling them when they vest and reinvest in a diversified portfolio aimed for long-term growth. This will reduce your risk exposure by reducing a concentrated position in one stock.

What are the tax implications with my RSUs?

The value of the RSUs is taxed at your ordinary income tax rate. If you do not know what federal tax bracket you are in, dig out last year’s tax return and find your “taxable income”. Line that number up with income brackets to get your marginal tax rate.

Often, at vesting, the plan is set is up to sell a portion of your vested shares to cover the cost of the taxes. So, in our example above, with the 40 RSUs that vest after one year, you might end up with 28 shares of stock because 12 shares were sold to cover the taxes.

Both the RSU income ($4000) and the taxes paid ($480) on this income will show up on your next paycheck and year-end W-2.

But wait, that’s not all. If you hold onto your shares and sell them later, the next layer of tax will be capital gains.

Gains on shares sold prior to one year and one day after vesting are taxed at your short-term capital gains tax rate (which is the same as your ordinary income rate), and shares sold after that point are taxed at the lower long-term capital gains rate. If you sell your shares right after they vest, you will likely avoid additional taxes (but also, alas, potential gains) entirely. Learn more about the differences between short- and long-term capital gains taxes.

Here is a snapshot of the tax implications at each stage:

  1. Upon being granted any RSUs, but before vesting, you aren’t on the hook for any taxes.
  2. Upon vesting, RSUs are taxed at your ordinary income tax rate.
  3. If you sell before one year and one day after vesting, you’ll pay short-term capital gains taxes.
  4. If you sell after one year and one day, you’ll pay your long-term capital gains tax rate.

What happens to my RSUs if I leave the company?

The reason you leave the company could have a bearing on what happens to your RSUs, so check the terms of your employment agreement to be certain about what to expect.

But it pays to be familiar with the details of your vesting schedule because typically if you leave your employer before your vesting date, you will forfeit your shares. As I mentioned earlier, there are two types of vesting schedules: graded vesting and cliff vesting.  If you have a graded vesting schedule, that could mean you’ll still get a percentage of the full total of your RSUs if you’ve passed any of the milestone vesting periods. If you have a cliff vesting schedule and haven’t vested, you’ll likely walk away empty-handed.

How important is diversification when it comes to RSUs?

Diversification of your portfolio is always an important consideration, and you do want to make sure that your portfolio is not too concentrated in one company’s stock. Your investment goals and risk tolerance are two important factors to consider with how you diversify, and a CERTIFIED FINANCIAL PLANNER™ professional can help you find the mix of investments that supports your financial goals.

Kelly Luethje, CFP®, is Founder of Willow Planning Group, LLC. She provides financial education and guidance to help you live life on your terms. Kelly can usually be found on a mountain or by a lake working working virtually with clients across the country.