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Mandy Pham, CFP®, CFA
Historically, stock options have been the vehicle of choice for equity compensation in Silicon Valley. However, over the past two decades, the increasingly competitive war on talent and the dramatic impact of the dot-com crush brought about a meaningful change in how tech companies now use equity compensation.
In 2003, Microsoft was among the first big tech companies to announce the move from option grants to restricted stock units (RSUs). Bill Gates explained at the time,
“When you win with options, you win the lottery… The fact is that the variation in the value of an option is just too great. I can imagine an employee going home at night and considering two wildly different possibilities with his compensation program. Either he can buy six summer homes or no summer homes. Either he can send his kids to college 50 times, or no times. The variation is huge; much greater than most employees have an appetite for…So, what we do now is give shares, not options.”
Today, if you work for a big public tech company such as Apple, Google, Facebook, Amazon, Adobe, or Cisco, to name a few, – chances are a major portion of your long-term compensation now comes from RSUs.
When your employer gives an RSU grant as part of your compensation package, you are essentially promised a certain number of shares in that company, with strings attached—a vesting schedule and often for private companies, liquidation events such as an IPO or acquisition.
A vesting schedule determines how long you will have to wait before your RSUs vest, whereupon restrictions on the RSUs are removed and the stock shares are delivered to your account. Most common vesting schedules are in monthly or quarterly increments, over a period of three to five years, often with a one-year cliff.
Let’s look at an example—on January 2, 2019, Kate accepted a senior position at Adobe. Along with a great salary and bonus, she also received a grant of 4,000 RSUs that will vest quarterly over a four-year period with a one-year cliff. The one-year cliff means that Kate will not receive any shares during her first year of employment, and the 1,000 shares that are supposed to vest in the first four quarters will all vest upon her first-year anniversary.
On January 2, 2020, assuming she is still working at Adobe, Kate will receive 1,000 shares, and then an additional 250 shares each quarter thereafter for the next three years. Most likely, Kate will receive refreshing grants every year so that her RSU payout will continue after the first three years. If Kate quits for a better job (or is terminated), all of her unvested RSUs will be forfeited.
The good news is that RSUs are almost guaranteed to be worth something, unless the company goes bankrupt and its stock price goes down to zero. The value of an RSU can fluctuate substantially though, depending on the company’s stock price on the day it vests.
In Kate’s example, say ADBE was trading at $200/share when her grant was issued; so the expected payout on her first-year anniversary is $200,000. Assume that, thanks to the efforts of Kate and her colleagues, Adobe has had a great 12 months and its share price increased by 50%. Kate’s gross payout is now worth $300,000. But of course, the opposite scenario can occur to be true. If the company doesn’t do well and its stock price drops in half (in 2019, think UBER, TRIP (TripAdvisor) or BE (Bloom Energy)), the value of Kate’s RSU income will be also be cut by half.
The value of RSUs becomes taxable income in the year they vest. The fair market value of the shares on the vesting date is taxed to the employee as earned income and is subject to payroll, federal, state and local taxes.
Unlike with an incentive stock option (ISO) or an employee stock purchase plan (ESPP), there is no holding period that will give you special tax treatment for RSU income. You also don’t need to worry about Alternative Minimum Tax (AMT) as is the case when you exercise ISO.
If you decide to hold on to the shares upon receipt, tax rules for capital gains and losses apply as if you purchase those shares on the open market on the vesting date: long-term capital gains treatment if you hold the shares for longer than one year, and short-term capital gain treatment if you sell the shares before the one-year mark.
It is worth noting that RSUs income and other bonuses are subject to mandatory “supplemental” withholding rates, which is fixed at 22% for federal and 10.23% for California income tax. Given that the current highest marginal tax brackets are 37% and 13.3% respectively at the federal and California level, the amount of tax withholding might not be enough. Therefore, it is important that Kate consults with her financial advisor or accountant to determine whether she needs to increase her withholding on her salary or to make additional estimated tax payments to avoid an unexpected tax bill and potential penalties.
It’s important to determine whether to sell or hold your vested shares within the context of your comprehensive financial plan. Are there short term financial goals that you need to save for, such as a down payment, an upcoming tuition bill for your kid in college, or a big family trip? Should vested shares be sold to subsidize daily cash flow so that you and your spouse can put more money into 401(k)s and a deferred compensation plan to save on taxes? How close are you to retirement?
From the employee’s perspective, RSU income is just another form of compensation, and the fact that it’s delivered in shares instead of cash should not be a relevant factor. Kate should ask—had she received $300,000 in cash, would it make sense to then use that money to purchase additional shares of ADBE? As Kate continues her employment at ADBE, she will have ongoing exposure to company stock through her unvested RSUs, ESPP shares, and any other types of equity compensation. In addition, Kate’s salary and cash bonus is also dependent on the company’s performance. All things considered, it might not be prudent to further increase her risk exposure by keeping vested RSU shares.
Most of us might have heard of stories about early FAANG employees who held onto their stocks, which are now worth a fortune. But then there are also the stories of GoPro (GPRO), FitBit (FIT), Bloom Energy (BE) or most recently, Uber (UBER) employees, who learned the hard way a lesson about not putting all of your eggs in one basket.
By working with your financial advisor and tax consultant, you can put together a financial plan to retain enough shares for upside potential while still protecting your family’s financial future.
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