Here's the scenario: you’re called into your boss's office and given a bonus check in recognition of your work and dedication to the company. You didn't know the exact amount of this bonus prior to receiving it, but you knew it was coming, and you're delighted the day has finally arrived. Do you:
Book a tropical vacation and then head down to your local auto dealer during lunch to put money down on a new Tesla or Range Rover.
Plan on a nice celebration dinner, but use the bulk of the funds according to a plan you've already thoughtfully mapped out (e.g., using a portion of the bonus to pay down your mortgage, putting a portion toward your children’s college funds, and investing the remaining amount in a diversified, high-quality portfolio designed to buy your future freedom (retirement!)).
Put the entire check into your investment account and use it to buy stock in your employer's company.
Most people know intuitively that "Option B" is the prudent thing to do, "Option A" is the fun thing to do, and "Option C" is likely the risky thing to do because it can lead to an over concentration of employer stock, which is potentially risky and may cause you to miss participating in other attractive investment opportunities. Yet, confusion about the taxation of restricted stock units (RSU) and a lack of understanding about the mechanics of RSUs lead many people to inadvertently choose Option C, the risky route!
Restricted Stock Units
RSUs are grants of company stock given to employees at the discretion of the employer. The stock is "restricted," meaning it has a vesting schedule that must be met before the stock can be sold. RSUs should not be confused with stock options. RSUs do not have the leverage component associated with company stock options.
If you choose to hold stock obtained from RSUs vesting, you are simply betting that your company stock will outperform a diversified portfolio over time. This may happen, but then again, it may not happen. It certainly will not happen without taking on a lot more risk than a diversified portfolio and likely much more volatility. This is a very different decision than choosing how long to hold stock options before expiration, where the options' inherent leverage can greatly magnify an option holder's gains over time, even if the company stock return is mediocre.
Another point that commonly trips up executives is the tax associated with RSUs. At vesting, the fair market value of the RSUs is taxed as ordinary income—effectively the same as a cash bonus. In most cases, nothing has been paid for the RSUs; otherwise, there would be a tax basis. So, it really is that simple: when RSUs vest, income taxes are due. (An advanced tactic, the "Section 83b election," would change the math on this situation.)
When thinking about your RSUs, there are a couple of important points to remember:
- From a tax standpoint at the point of vesting, the value of the stock obtained from the RSUs is effectively the same as if you were paid a cash bonus.
- From an investment standpoint, there is no leverage or special advantage to holding on to company stock obtained from vesting RSUs as there may be with stock options.
Keeping these considerations in mind, let's look at the above scenario again. In that type of a situation, many times I've seen people effectively choose Option C because they do nothing at the time their RSUs vest. They simply hold on to their company stock. The vesting restrictions are gone, the taxes have effectively been paid, It is as if they took a cash bonus and used it all to purchase company stock! They don’t consider other financial options, which, as I noted above, could be less risky and more beneficial to their financial goals.
As always, your specific situation may include mitigating circumstances that also need to be a part of your decision making. Perhaps your company was recently the subject of a news item that caused its stock price to plummet; however, you have a strong conviction there will be an equally quick rebound, so you want to hang on to the stock. Or perhaps you are working toward an executive company stock holding requirement and need to hold onto a large portion of your company's stock.
RSUs: Smart, Informed Choices
When the time arrives for you to make a decision about your RSUs, stock options, company stock, non-qualified deferred compensation, or other complex planning areas, be confident in your decision-making. Taking a few minutes to talk to a Certified Financial Planner(TM) professional who specializes in executive compensation could be a wise investment!