There are three common types of equity compensation – Restricted Stock Units, Incentive Stock Options, and Non Qualified Stock Options. They all operate differently as financial instruments, but for the purpose of this article we’re going to focus on the taxation of RSUs.
Restricted Stock Units (RSUs) are usually awarded to employees on a vesting schedule. Sometimes this is spread over 3 years, 5 years, or on a “cliff” where all if it is awarded after a specified amount of time. RSUs are taxed when the shares are delivered to you, which is generally at vesting. Even if you choose not to sell the stock when it vests, it is recognized as compensation when you receive it and is subject to income and payroll taxes. If you choose to hold the stock and it appreciates, the difference between your sales price and the fair value at vesting will be subject to capital gains taxes.
Simple Example: Paying tax as you go, but holding onto the stock. This would be the strategy to employ if you think the stock is going to continue to appreciate
Shannon got a job at Amazon in 2016 and was awarded 30 shares of stock over a three year vesting period. She lives in Virginia and files taxes jointly. Her state income tax rate is 5.75% and her Federal Income Tax Rate is 24%, for a combined income tax rate of 29.75%. Her combined capital gains rate is 20.75% (15% Federal and 5.75% State)
1/2017 – $AMZN trading at $800, Shannon receives 10 vested shares worth $8,000 and pays $2,380 in income taxes*.
1/2018 – $AMZN trading at $1,300, Shannon receives 10 vested shares worth $13,000 and pays $3,868 in income taxes.
1/2019 – $AMZN trading at $1,600, Shannon receives 10 vested shares worth $16,000 and pays $4,760 in income taxes.
2/2020 – $AMZN trading at $2,000. Shannon sells her 30 shares for $60,000. She’s paid taxes on $37,000 worth of compensation in the form of stock so far, which is her basis for capital gain. She owes capital gains taxes on $23,000 (proceeds from sale minus basis). The capital gains bill is $4,773.
All told, Shannon pays $15,781 in taxes to receive $60,000 after selling her shares. The way to view RSUs you receive at vesting is that they are the same as cash at that point. If you’re debating whether to keep the stock or sell it immediately, ask yourself – would I buy my company’s stock if they just paid me this money in cash?
Before making any decisions regarding your equity compensation, you should assess the risk and tax consequences. You may be subject to tax withholdings or be required to make estimated payments on the income. If you have questions on how your equity compensation plan works, start a conversation with us.
* Note: Often times, a portion of your shares (commonly 22%) will be withheld when they vest for the purposes of tax withholding, the same way your employer withholds portions of your normal paycheck for taxes. This withholding may or may not be sufficient to cover the income tax bill, depending on your tax bracket.
Let’s do simple example for my home state of Virginia:
- Joe and Stacey are married and have a daughter, Julia, who is 5. They plan to contribute $3k per year every year until she heads off to college at age 18. They have taxable income of $150k per year.
- Virginia’s top marginal bracket is 5.75%, and that bracket begins at only $17,001 of income.
The value of the state income tax deduction for contributing $3k this year is $172.50 ($3k x 5.75%). Doesn’t seem like a lot, right? Over 13yrs (age 5 to 18) that’s $2,242. Not nothing, but not an eye-popping figure, either.
Now let’s assess the capital gain tax savings:
- In the 13 years we contribute, we’ll have put in $39k total into the plan. If we assume a 6% rate of return over that investment period, that gives us a balance of $56,646
- The capital gain will be $17,646 ($56,646 – 39,000). At $150k taxable income, your Federal capital gains rate is 15% and your state rate remains the same at 5.75%
- The resulting tax bill dodged on capital gains is $3,662 ($17,646 x 20.75%)
So all told, Joe and Stacey get an actual dollar benefit of $5,904.
Tax rates, deductions on contributions, and plan options vary greatly state by state. There are also alternative strategies and vehicles for college savings that you can consider. Be sure to run the numbers yourself to determine if 529s make sense for you.