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What the heck are RSUs?
Are you super confused about what an RSUs are and why you should care about them? This post is for you! Jump in to learn about stock compensation!
Disclaimer: I am not a CPA. This post only serves to provide an introduction to how RSUs, including how they can be taxed in the U.S. Any recommendations provided within this article represent only my own opinions.I am not affiliated with any of the websites or products I discuss in this post.
Hello avid reader! As you may be able to tell from the title of this post, I'm gonna be discussing RSUs today: what they are, how to understand their vesting, tax implications, and why they should be a core consideration whenever you are offered a new role in a company. For those of you who have read my "How to evaluate a SWE offer" post, you got a very high-level overview of what RSUs are. This is where we get some more depth 😃.
You might've heard that you "need to grow your equity", or that "equity is what makes you rich." What "equity" refers to is not cash compensation (which is still important obviously, because it's what you will primarily live on), but rather some part of a company you own. As that company does well, its value rises and therefore the value of your part in the company also rises. That "part of the company" is subdivided into units referred to as "shares" or "stock" (the two terms are used pretty interchangeably). This is not money in your bank account, but rather a representation of value that can be converted into cash upon selling.
Within the past couple decades (as of the time of this writing; I have no clue how long this blog will be archived in whatever newfangled storage system we'll have in the next 50 years 🤣), many companies both public and private have offered shares to their employees as part of employee compensation packages. These shares are referred to as Restricted Stock Units (RSUs).
In this post, I will explain a bit more about how RSUs should factor into your overall understanding of total compensation ("total comp"), the difference between private vs. public RSUs, tax implications from receiving and selling RSUs, and some assorted additional topics on stock compensation.
(Note: If you want a quick primer on calculating taxes for cash-based compensation, so you have a baseline understanding before considering RSU tax implications, I'd recommend reading my post "How do taxes work in the first year?".)
Where did RSUs come from?
Tl;dr: Accounting scandals in early 2000s that came from stock option snafus.
In the early 2000s, there were multiple accounting and tax evasion scandals coming out in the news regarding large corporations and their executives engaging in malpractice with stock options. So an alternative form of equity compensation was needed.
Out of this landscape, RSUs, which were previously reserved primarily for executive-level and above, became a lot more common for all employees. They provide an easier way of building equity in a company, while still following all applicable tax laws.
How do RSUs work?
A Restricted Stock Unit (RSU) is a share of a company provided to you if you have been working at a company for some amount of tenure. This share of the company is treated as ordinary income (because there is value you derived which was given to you, even though it's not as liquid as cash), which is important for tax considerations.
In addition to your salary (and potential bonus targets), companies will also provide you with an RSU grant in your offer package. That RSU grant will be for some number of shares. Depending on company sizes, whether they're public or private, and share prices, among many other factors, the exact size of the RSU package in your offer will likely differ between companies. The vesting schedule can also differ among companies.
Note that you must also be at a company for the duration of the vesting schedule to receive all the shares in your initial grant. If you leave, then any shares that have not been vested yet will not be given to you and they will not continue to vest.
What is a Vesting Schedule?
Unlike a sign on bonus or an annual bonus, which are both provided as a lump sum, RSUs are not all given to you in one transaction. Rather, you are granted some number of RSUs, with a vesting schedule, and normally with a vesting cliff. The grant says, "We, company A, are offering you X number of shares over Y period of time, with a vesting cliff of Z years, and thereupon the remainder of the shares will be vesting over this vesting schedule." Let's dissect these components of the grant statement.
X number of shares is pretty clear. That means you will receive a total number of X shares for this grant. The Y period of time means you will receive X shares over time. The vesting cliff and vesting schedule are the complicated parts.
A vesting cliff is designed to retain you within the company for some minimum amount of time, known as the vesting cliff. A common vesting cliff is 1 year. What that means is that you will not receive any shares for 1 year. After that point, you will receive the amount of shares, in one lump transaction, that should've vested over that year. And then the remaining shares will continually vest over a vesting schedule.
Let's do an example: Imagine you have 4,000 shares in a 4-year grant, with a vesting cliff of 1 year to receive 1/4 of your grant, and then the vesting schedule is once every quarter. And you stay for at least the 4 years it will take before you receive all the shares in the grant. Let's do some math to see what this vesting schedule will be like:
After year 1, we get 1/4 of shares = 1,000 shares Remaining shares from grant = 4,000-1,000 = 3,000 shares Number of vest periods = 4 quarters/year * 3 years = 12 Shares per vest period = 3,000 shares/12 vest periods = 250
If you like fractions more than absolute numbers:
After year 1, fraction of shares remaining = 3/4 Number of vest periods = 12 Fraction of shares per vest period = 3/4 / 12 = 3/48 of grant
Imagine you join the company at the beginning of the year (2022). The schedule we would see for when we receive shares would be like so:
Public vs. Private RSUs
In the example above, we never discussed selling shares, solely receiving them/vesting them. The major difference, between public vs. private companies, that comes into play when you want to sell vested shares for income has to do with liquidity. If the shares are private, you may not be able to sell them.
When a company is public, the shares you receive are fairly liquid. You can sell them within the broader stock market and they are the same as owning any other public stock in your portfolio. However, when a company is private, the broader market cannot just buy shares from you. So it's up to the company to provide you with liquidity opportunities. They could offer to buy back shares, or maybe there are other investors for the company who would want to buy more shares. If neither of those conditions are true, or if the company simply will not allow selling of shares unless the company is public, then you have to wait for an IPO.
The main point is that because there may not be liquidity for private RSUs, you cannot treat them as additional income per year. However, you could potentially do that with public, well-known companies' RSU packages because you can see all of their stock price performance since the day they had their IPO.
A Word on IPOs
Joining a private startup that is offering RSUs can be very lucrative, but it can also be frustrating to have to wait for an IPO. And it's even worse if after the IPO, the shares drop in value. Couple this with a lockup period (a period of time after an IPO when employees have to just hold shares and not sell) and you start to get a headache.
As an example, consider Meta (previously Facebook). Facebook had their IPO with a share price of $38 in May of 2012 and then the shares went down in value. It took until August of 2013 for the share price to come back to the level it was at close of market on the day of the IPO ($38.23). Granted, employees could have received RSU packages with internal share price lower than that of the IPO price, which means they still could've made money if they sold on the day of the IPO. But they could've also had a lockup, which meant they'd just have to wait and watch the share price go down. And then they'd have to wait some more after the end of the lockup period for the shares to come back up in value. Refer to this Google Finance link to see FB's stock performance.
Another example is Lyft. Their IPO was on March 29, 2019 with a share price of $78.29 at the end of the trading day. The share price then continued to descend. As of the time of writing of this post, the share price has still not come back up to the level that it was at the IPO. Refer to this Google Finance link to see LYFT's stock performance.
Tax Implications for RSUs
Because you are receiving value from RSUs being provided to you, they are subject to taxation by state and federal governments. "But wait! This wasn't cash! I didn't sell anything," you cry and shake your fists. Doesn't matter. RSUs are still a form of value, and even though they're not liquid, they get taxed 😫.
So to help you with your tax obligations, a lot of tech companies will do what's called a "sell-to-cover" transaction, where they will automatically sell some shares to cover the tax on the income you made from receiving shares. Thing is, they frequently undersell 🤦♂️. For federal income tax, the minimum is typically 22% withheld, so that's what they do. However, if you're in a higher tax bracket, that means you will owe more to the federal government, come tax time the next year.
To give yourself a quick primer on calculating income taxes, I recommend reading my post "How do taxes work in the first year?". That post provides a good foundation for understanding taxation based on solely cash compensation, without investments. Investments are just one more thing you can tack on, which will affect your Adjusted Gross Income (AGI). RSUs are investments 😃.
The two main things to remember are:
You are taxed when RSUs vest, because there is value you gained: the RSUs are worth something, even though they're not as liquid as cash.
You are taxed on capital gains/losses when you sell RSUs. In the case of capital gains, the amount you are taxed depends on how long you have held the RSUs.
Capital Gains Taxation
As mentioned above, you are taxed whenever you receive new shares from RSUs vesting. Those RSUs that have vested are providing you new value, and that new value is taxed as ordinary income (just like your cash compensation). Now, you have a choice. You can either:
Hold the shares
Or sell them after some period of time
The "after some period of time" part is where things start getting interesting. If you sell the shares less than a year from the date they were vested (not granted; I mean specifically when the shares show up in your personal brokerage account), any gains you have on the shares will be taxed as ordinary income (meaning, it's taxed just like cash compensation, within your tax bracket). However, if you sell the shares after a year from the date they were vested, the gains you make are taxed as capital gains, which have preferential tax treatment (lower tax obligation).
As of the time of writing of this blog post, the federal capital gains brackets for single filing are:
State capital gains/losses tax rules can be totally different from federal capital gains/losses rules. In CA for example, there is no difference between short term and long term holdings and they are both taxed as ordinary income.
Example of RSUs Being Taxed
Let's work through an example where you are receiving RSUs and then selling them some period of time later. We will calculate federal income taxes, for single filing status (I'll leave state taxes, or other filing statuses as an exercise to you 😁). Note that I will also ignore FICA taxes to simplify this example, however they are covered in my post "How do taxes work in the first year?".
Setup of example:
$150k base salary (let's say it stays the same for this exercise; should be going up though each year in reality)
4 year RSU grant for 4,000 shares
1 year vesting cliff, and then you get 1/4 of shares
Equal quarterly vesting of remainder of grant after cliff
$30k sign on bonus
You contribute the full $20,500 to Traditional 401k (as of 2022 401k contribution cap) (let's say it stays the same for this exercise; should be going up each year though in reality)
Company does not do sell-to-cover
Let's say you joined your company in the beginning of 2021. Now, it's the beginning of 2022 and you have just had a quarter of your grant vested (you just passed the 1 year vesting cliff). You will hold the shares for a year (and new shares will vest quarterly in the meantime). And in the next year, you will sell the 1,000 shares that vested at the beginning of 2022. We will calculate the taxes you will pay in 2022, 2023, and in 2024.
The upcoming event timeline looks something like this:
Let's also say that the share price values are the following:
Federal Income Taxes Paid in 2022
I'm going to skip all the explanatory detail within the post "How do taxes work in the first year?" and instead just show you direct numbers after calculation. For a more detailed explanation of how the line items are calculated, please refer back to "How do taxes work in the first year?". The new part, relative to that post, is what we do with RSUs so I will point those differences out as we go.
Also, remember from setup of the exercise that the company is not doing sell-to-cover. I did that to make the numbers easier so we can calculate our full tax liability without too many underlying assumptions 😃.
Come tax time in April, we have to count our salary from previous year, any bonuses, and any share value we have vested.
Adjusted Gross Income = $180,000
Taxable income = $146,550
Traditional 401k Contribution: -$20,500
Standard Deduction: -$12,950
Federal income taxes = $29,192.76
Federal Income Taxes Paid in 2023
Unlike the previous year, we now have these changes:
No sign on bonus
1750 shares we now own from vesting, but they vested at different values (because of the Share Price Values table above)
Let's calculate the income we got from all those shares vesting. We can do that by calculating each tax lot's value and then summing those up:
So we derived a total of $89,000 from vested shares. That would be reported as the Additional Taxable Income in a W2. We would add that to our cash income to derive AGI (Adjusted Gross Income) and then we would be able to calculate Taxable Income.
I'm going to use the tax brackets for the 2022 tax year (the taxes paid in 2023 based on income made in 2022).
AGI = $261,500
Annual bonus: $22,500
Additional Taxable Income: $89,000
Taxable Income = $228,050
Traditional 401k Contribution: -$20,500
Standard deduction: -$12,950
Federal income taxes = $53,569.49
Federal Income Taxes Paid in 2024
In 2023, we planned to sell the 1,000 shares that vested in the beginning of 2022. Let's say we sell in 2023 Q1. So new changes are:
New shares vested, at different price points
In Q3, selling 1,000 shares vested in 2022
Note that I will be using the 2022 Tax Brackets (for taxes paid in 2023) because the 2023 Tax Brackets are not available yet.
Time to do some calculator work 😁:
AGI = $228,000
Annual bonus: $22,500
Additional taxable income: $55,500
Taxable income from cash = $194,550
Federal income taxes from cash = $42,487.50
Taxable Income from Capital Gains = $4,000
1000 shares * ($54 - $50)/share = $4,000
Federal capital gains tax = $600
Taxable income excluding capital gain is within 15% bracket
Capital gains tax = 0.15*4,000 = $600
Total federal income taxes = $42,487.50 + $600 = $43,087.50
Assorted Topics on Stock Compensation
Congrats on getting to this point in the post. This one was a real whopper. Give yourself a pat on the back!
As I was writing this post, I started getting ideas for other topics related to stock compensation, but I wasn't sure where to place them among the larger topics above. So I have added them as a sort of potpourri for you 😃.
I referred to these a bit above, but I wanted some more explanation for anyone who is curious about these.
When you have shares you own for the company you work in, whether you bought those shares yourself, or they were given to you over time (vesting), there are periods of time in which your company will not want you to sell any shares. The reason why is normally to do with protecting against insider trading.
Imagine that the company is about to release earnings and you know something that the rest of the public doesn't know (the earnings haven't been released yet, so theoretically only employees could know). That "something" you know is referred to as Material Non-Public Information (MNPI). It's information that could materially affect whether an investor buys or sells your company's stock.
To protect against insider trading, companies normally have blackout windows near their earnings dates so that employees don't trade using information that is not yet known to the public.
In addition, they could add blackout windows around holidays or boundaries (beginning or end) of their fiscal years to simplify accounting.
The duration and number of blackout windows throughout the year can vary widely among different companies. Make sure to ask about this if you are evaluating new roles.
ESPP is a fantastic program. I cannot recommend it highly enough for anyone who has the ability to do this.
ESPP stands for Employee Stock Purchase Plan. ESPP programs are designed to allow employees to acquire shares of their company's stock at a discount. The way this works is that employees use after-tax money from their regular income to purchase shares of the company at normally a 15% discount.
A standard ESPP term is 6 months. What that means is that the plan renews every 6 months. Over the course of 6 months, you have a little bit of your paycheck taken out each time to allocate money toward the purchase of your company's shares. Then, at the end of the 6 month period, the company compares the share price at the beginning of the 6 month period and the share price at the end. They take the minimum of those two values, decrease the selected value by 15%, and then buys shares for you AT THE DISCOUNTED PRICE, using the money you've been building up over the 6 months from each paycheck's allocation toward ESPP.
Let's do an example:
Say you make $5,000 gross pay per paycheck every 2 weeks. And for sake of simplicity, let's align the pay periods to the beginning of the 6 month window (meaning, you're not paid on the week that the window begins). Also, let's imagine 24% of every paycheck is taken out in taxes.
Gross pay per paycheck = 5,000 Net pay = 5,000*(1-0.24) = $3,800 Amount allocated toward ESPP = 0.15*3,800 = $570 Assume 2 pay periods per month. Number of pay periods = 6 months * 2 pay periods/month = 12 6 month total = 12 pay periods * $570/pay period = $6,840
Now we need some sample data for the share price:
Now that we have this data, let's see how many shares we get at the end of the ESPP period (6 months later):
MIN($50 per share, $70 per share) = $50 per share Share price for ESPP = $50*(1-0.15) = $42.50 per share Num shares acquired = $6,840 // $42.50 per share = 160 shares
So you just got 160 shares, at a 15% DISCOUNT! Woohoo! And the best part is, because you used after tax money to purchase the shares, you don't owe any taxes when you receive the shares, unlike with RSUs where you owe taxes the moment the shares vest. You will only ever pay taxes on capital gains/losses when you sell the shares you purchased through ESPP.
Counting Shares Toward Mortgage Loan
The last fringe benefit I would be remiss to not discuss is that depending on the company and its reputation among banking institutions in the financial industry, you may actually be able to use your shares toward the down payment of a home. If the company is well-known, with reliable RSU distributions to its employees, your mortgage underwriter may just be able to use your current shares toward collateral for your loan and may also be willing to underwrite you slightly higher if you share your vesting schedule. The reason why is because if the company is public, the mortgage underwriter can estimate roughly how much value you will gain over each quarter from the number of shares vesting * share price.
Note that this is a super fringe benefit. Not all banks will have this option and they likely will not publicize it either, but you don't know if you don't ask. Who knows? The shares you're accumulating may be able to help you purchase the home of your dreams. For more info on asset usage for home purchase, refer to my blog post "Buying a condo in SF".