Today, fewer companies are offering traditional stock option plans to their employees than ever before. Instead, companies continue to migrate toward restricted stock units or RSUs as the preferred method of equity participation for employees. Even the option heavy technology industry has been increasing their use of RSUs. In fact, according to management consulting services leader Aon Hewitt, the number of technology companies utilizing RSU focused plans has increased from only 3 percent in 2003 to nearly 75 percent today. While there are a few reasons for the increase, market downturns have contributed toward employee frustration over receiving stock options that may become worthless before they can be exercised due to variables like overall market performance – a factor outside their control. Despite the preference by some employees and the increased adoption, there are many misconceptions regarding the use of RSUs that executives and employees should be aware of. If your employer currently offers RSUs or you are considering an employer that does, understanding the mechanics of RSUs is critical to maximizing their impact on your personal goals.
The mechanics of RSUs
RSUs are a mechanism for employers to grant company shares to employees. The grant is usually subject to a vesting schedule based upon length of employment or other performance based metrics or goals. The “restricted” stock becomes “unrestricted” and shares are typically received after the vesting date is met. Vesting schedules can vary with many set up as a “graded” or “cliff” schedule. For example, an employer has a 4 year “graded” schedule and grants 10,000 RSUs to an employee. 2,500 shares will vest each year and all shares will be vested at the end of 4 years. Once the shares are vested, the employee can choose to keep or sell the shares depending on their personal financial goals. Keep in mind that in some cases, the company may simply distribute cash equal to their value and no stock is actually received at vesting.
One of the primary reasons that some employees prefer RSUs over stock options is based upon the fact that RSUs will generally have some value to you as long as your company is in business – even if the value of the stock drops below the price it was at on the date it was granted to you.
For example, an employee is granted 5,000 RSUs when the value of the company stock is at $10 per share. Unfortunately, the price of the stock dips to $5 per share on the vesting date. Unlike a traditional stock option that could be worthless at this point, the RSU still has a total before tax value of $25,000. ($5 share price multiplied by 5,000 shares) While this is certainly less than it would have been if the stock performed better, the employee still realizes some value. The comfort RSUs can provide some employees has caused some in employers to modify the structure of their plans.
One of the biggest misconceptions employees have about RSUs is centered on the misunderstanding of how RSUs are taxed. RSUs are taxable when the shares become vested and are liquid - not when they are granted to you. This means that the value of the stock is taxable even though you haven’t actually sold it yet. The value of the shares on the vested date is taxable at ordinary income rates – which can be significant. As a result, some companies offer to withhold a portion of the newly vested stock to pay taxes. If you choose to hold onto the vested shares, capitals gain taxes will also be paid on any appreciation in value above the market price of the stock on the date they vested. Be sure to plan carefully here as you want to prevent any unintended tax surprises down the road.
Diversification vs. Concentration
Participating in the success of your company through RSUs can be a great way to increase your overall compensation. However, it important to remember the basic tenets of investing and diversification. Many analysts recommend holding no more than 10 percent of your investable assets in company stock. While this may be difficult for executives and employees receiving sizable grants, it is critical to be aware of the risk of being concentrated in one stock. Ask yourself, If I didn’t work for ABC company, would I have $200,000 worth of company stock? If the answer is no, then you should consider rebalancing your portfolio to improve your diversification. Also, remember that once the shares are vested and you are responsible for paying ordinary income tax, there is not necessarily a tax reason to continue to hold the shares. Unlike stock option strategies that may allow you to avoid paying ordinary income taxes if exercised stock options are held for greater than one year, RSU value is going to be taxed as ordinary income at the time of vesting. As a result, diversifying your investments should be at the top of the priority list. While diversification does not protect against investment losses, concentrating your holdings in one stock can increase your portfolio risk.
RSUs can substantially add to overall compensation while also providing value, even if the value of your company stock has declined since your grant date. However, some employees fail to properly diversify holdings after granted shares vest. Since everyone’s situation is unique, consider speaking to your tax, legal and financial adviser to determine how best to leverage RSUs for your situation.
Kurt J. Rossi, MBA, CFP®, CRPC®, AIF® is a CERTIFIED FINANCIAL PLANNERtm Practitioner & Wealth Advisor. He can be reached for questions at 732-280-7550, kurt.rossi@Independentwm.com, www.bringyourfinancestolife.com & www.Independentwm.com. LPL Financial Member FINRA/SIPC.