In Depth Understanding of Employer Stock Compensation (Part 2)

Part 2 of Employer Stock Compensation. In this part we will continue with advice on planning around your Restricted Stock Units (RSUs) (See Part 1 Here)

Have you accumulated substantial employer stock in the form of RSUs over the years? Does this employer stock position represent a substantial portion of your overall net worth?  Are you trying to understand the tax impact of selling these to reduce risk and diversify the proceeds? If you answered yes to any of these questions below are three sales strategies to consider when it comes to selling your RSUs.

Before we get into the three strategies, lets first take a quick look at what Restricted Stock Units (RSUs) are and how they are taxed.  From there we can dive into some effective ways to manage the sale of these to reduce risk in your portfolio and overall financial plan.

Restricted Stock Units or RSUs are a form of compensation to employees that result in the employee receiving the company’s stock upon certain conditions being met - hence the word, “Restricted” Stock Units. The restriction is in the form of a vesting period or service period.  The employee will be granted RSUs, but on the date of grant they won’t actually be able to do anything with them.  It’s only when they vest that ownership has transferred and they are yours. In many situations they will vest over multiple years. For example, you receive 100 RSUs today that will vest evenly over the next 4 years. What this means is you’ll receive 25 shares or 25% of the original 100 each year until four years is up and you’ve fully vested the 100 shares. This does mean you’ll also need to be with the company by the time during that vesting period to receive the full benefit.

Let’s take look at how RSUs are taxed so we can understand the tax attributes which will then drive the sale strategies behind them.  Ultimately RSUs are fairly straightforward on the tax side. At the date of vesting, the RSUs total value is included in income and taxed at ordinary income rates. For example, on the vesting date you receive 100 shares of company stock and the stock is trading at $50/share.  The total amount included in income will be $5,000 in the year of vesting (100 shares x $50/share).  Now, assuming you continue to hold the company stock after the date of vest, any subsequent gain will be taxed at capital gains rates, either short-term or long-term depending on the holding period.  Taking that same example, you continue to hold the same 100 shares for another year after date of vesting and now the stock is worth $60/share or $6,000 in total value. That unrealized gain of $1,000 ($6,000 total value less $5,000 cost basis) would be taxed at favorable long-term capital gains rates if you then sold them. Remember, your cost basis is the amount you included in income that year of vesting.  If the stock had decreased to $40/share you would have a capital loss of $1,000 – ($4,000 total value less $5,000 cost basis).

In most instances, if you have built up substantial RSUs you likely have some built in gains or losses related to the stock that you’ll want to navigate around. Now let’s dive into the sale strategies.

RSU Strategy Number One

Immediately sell your RSUs as they vest or sell recently vested RSUs to reduce exposure and taxes. In many instances we see highly paid executives receiving tens of thousands of RSUs vesting each year as part of their overall compensation. By implementing this strategy you will help curb increasing your overall employer stock position and also have very little tax impact on the sale. Remember, the total value on the date of vesting is always included in your income in that tax year – that is unavoidable if you sell the shares or hold them. But if you sell the shares as soon as they vest there will be very little gain/loss and you can diversify the proceeds.

RSU Strategy Number Two

Sell the shares that have the least unrealized gains first to maximize the amount you can diversify and minimize the tax impact. First sort your share positions by the unrealized gain percentage, small to large.  From there, identify the positions that have the least built in gain and look to sell those positions first. Let’s look at this with an example. 

In this example, the employee has accumulated a substantial amount of RSUs - total value of $162,500. The company’s stock has appreciated overtime creating an unrealized gain on all the positions of just over $90,000.

We’ve sorted the share positions from smallest to the largest based on the unrealized gain percentage.  From here, the first positions I would recommend liquidating first to reduce risk and reduce the tax impact would be the positions with the smallest unrealized gains. Let’s look at the 400 shares acquired on 8/1/2019 – that has an unrealized gain percentage of 7.69%. Which means I can remove $26,000 of company stock while only realizing and paying taxes on $2,000. Compare that to the 400 shares acquired on 8/1/2013 with an unrealized gain percentage of 69.23% or $18,000 in unrealized gain.  I would be removing the same total of $26,000 of risk and diversifying the proceeds but paying taxes on $18,000 in gain versus $2,000.  At 15% long-term capital gains rate, that is a tax difference of paying taxes of $2,700 versus $300, respectively – while removing the same amount of risk from the portfolio - $26,000.

RSU Strategy Number Three

Consider waiting to sell shares with unrealized gains that are approaching the one year holding period to achieve favorable long-term capital gains rates versus short-term capital gains taxed as ordinary income rates. In the example above all of the positions are in long-term status because they have been held for over a year. However, let’s say the first position of 400 shares with a 7.69% unrealized gain percentage was under the one year holding period at 10 months. Lets also assume the couples marginal tax rate is 32%. If the decided to sell the position before achieving the one year holding period for long-term gains, they would pay taxes at a rate of 32% versus 18.8%. (15% + NIIT 3.8%). So instead of paying taxes of $640, they would pay taxes of $376.  That is a 70% increase in tax by selling two months early!

If there are other shares you can sell at long-term gains rates, maybe consider selling those instead first to reduce risk and let that position achieve long-term gains status.

It’s important to note that you should always weigh the risks and benefits of selling today versus the potential tax savings of waiting. If the company stock is volatile where it could very well drop, then consider just selling today. Don’t let the potential tax savings get in the way of a better decision to sell. If that stock drops, the potential tax savings can be wiped out quickly with a depreciated stock price. Implementing these strategies is best executed with performing tax projections in the year of sale to understand the tax impact and whole picture.

If you have questions about your employer stock, utilizing effective sales strategies to reduce risk and taxes, or how this all relates to your retirement plan, schedule a phone call to discuss with a Phillip James advisor.

All the information contained herein is for illustrative purposes and should not be relied upon for tax, investment, or legal advice. You should consult with your Fiduciary Wealth Advisor to decide what is best for you based on your specific situation. It also helps if your advisor is a tax preparer to understand the tax impact of implementing specific strategies.