Understanding your plan may allow you to better prepare for and possibly reduce your taxes owed.
You may receive a portion of your income in equity from your company. Two common forms of equity compensation are Restricted Stock Awards (RSAs, sometimes referred to as Restricted Stock) and Restricted Stock Units (RSUs). Both RSAs and RSUs are employer plans designed to reward and retain employees by offering additional compensation in the form of company stock.
Read on to understand the key differences between the approaches, plan for taxes owed, and learn about potential tax saving strategies.
Overview and key definitions
With both plans, shares granted by your employer come with a substantial risk of forfeiture; meaning you will not receive the additional income (stock) unless certain conditions are met. Most often, you will receive the shares only if you are still employed at the end of the pre-determined period. Less often, you must meet a pre-determined performance goal to receive the shares. Generally, employees receive RSA or RSU shares as additional compensation without needing to pay anything for the shares. The day you are offered the shares is referred to as the grant date. The day the conditions are met and you receive the unrestricted shares is referred to as the vesting date.
What are restricted stock units (RSUs)?
Restricted stock units are a promise from an employer to grant shares to you. Before the shares are received, they are said to be unvested. Upon meeting the pre-determined condition(s), the shares vest and you receive them. As previously mentioned, there is a possibility that the shares never vest, and no taxable income is ever realized. Prior to receiving the shares, they are not actually titled in your name. The implications of this are that any dividends paid on the shares while they are unvested are generally not paid to you and you will not have voting rights that come with owning the shares.
What are restricted stock awards (RSAs)?
RSAs differ from RSUs in that the shares are yours when they are granted (and are usually held in escrow) but must be paid back to your employer if the pre-determined vesting conditions are not satisfied. This slight distinction means you receive any dividends paid and have voting rights prior to the shares fully vesting. The other difference with RSAs is that you have the option of choosing to do an 83b election (see below) which may change the taxes you pay.
Both plans are treated the same for tax purposes, unless you have RSAs and make an 83b election (more on this later). The value of the shares becomes ordinary taxable income when the vesting condition is met. If you hold the shares beyond vesting, capital gains or losses are calculated on the sale date.
The ordinary income per share realized when the shares vest equals the market price at the time of vesting less the price paid for the shares, if any (generally you pay nothing for the shares). For example, you are granted shares worth $10,000 but they are worth $15,000 when you satisfy the vesting condition. If you paid nothing for these shares, you realize $15,000 in ordinary income in the year the shares vest. If you had RSAs and received dividends during the period prior satisfying the vesting condition, those dividends are treated as ordinary income as well (they are not qualified dividends).
You are responsible for Federal, state, and FICA (Social Security and Medicare) taxes on this ordinary income. Employers are generally required to withhold these taxes when the shares vest, whether or not you sell them immediately. Some employers allow you to sell shares to pay the tax withholding. If this isn’t an option, you’ll need cash to pay the withholding taxes.
Capital Gains Income
Although we don’t generally recommend this, if you decide to hold your shares beyond the vesting period, you will realize capital gains or losses at the time of sale. Gains or losses are calculated by taking the difference between the sale price and the price of the shares on the vesting date. You will pay taxes on any gains and deduct up to $3k of losses from ordinary income. The gain / loss will be short-term if you hold the shares for a year or less from the date they vested. The gain / loss is long-term if you hold the shares more than a year from the vesting date.
Only available for RSAs, an 83b election allows you to choose which set of rules apply to the taxation of your plan. Choosing an 83b election allows the shares to be taxed based on the date the shares were granted. This distinction means that ordinary income may be calculated based on the value of the shares when they are granted as opposed to when they fully vest. Importantly, you also accelerate the payment of taxes to when the shares are granted as opposed to when they fully vest. Capital gains are calculated by subtracting the value of the shares at grant from the sale price. The determination of whether the gains are short-term or long-term is based on an initial purchase date equal to the grant date. With an 83b election, dividends can qualify for the special 15% capital gains tax rate, instead of being ordinary income. You must complete an 83b election within 30 days of the grant from your employer. You must send a copy of the 83b election to both your employer and the IRS.
The example below illustrates how filing an 83b election might reduce your taxes.
- No 83b election – 1,000 shares are granted (at no cost) when the price is $100. At vesting, each share is worth $150. You sell the shares two years after vesting, receiving $200 for each share. Absent the 83b election, your ordinary income is $150,000 and your long-term capital gain is $50,000. If you are in the 24% marginal tax bracket, your total Federal tax paid on this transaction is $36,000 on the ordinary income and $7,500 on the capital gains = $43,500.
- 83b election – Assume that all the details of the transaction above are the same except you made the 83b election within 30 days of the grant. Now your ordinary income is $100,000 (calculated on the value of the shares at grant, not at vesting). Your long-term capital gain is $100,000. If you are still in the 24% marginal tax bracket, your total Federal tax paid on this transaction is $24,000 on the ordinary income and $15,000 on the capital gains = $39,000. You save $4,500 in taxes, or a bit more than 10%.
Choosing an 83b election is beneficial when:
- You expect your RSAs to increase in value prior to fulfilling the vesting condition
- You plan to hold the shares beyond the vesting date
- Dividends are paid on your shares
- You are confident you will satisfy the vesting condition
- You have cash to pay the ordinary income tax prior to selling the shares
Despite the potential benefits, there are many scenarios where you could end up paying more (or a lot more) in tax by filing the 83b election:
- The biggest risk is that you might not satisfy the vesting condition. You would owe and pay tax as if you had received the shares on the grant date, even though you would never receive the shares. This is a considerable risk, as you’ll never recoup the tax you paid.
- If the price of the shares decreases after the grant date, you will have higher ordinary income and pay more tax than if you hadn’t filed the election.
RSU or RSA plans can be a substantial part of your annual compensation if you remain at your company and are able to meet the vesting condition. With an RSU plan, it’s important to understand and be prepared to have taxes withheld on your shares upon vesting. We recommend selling shares as they vest so you aren’t holding concentrated stock positions in your company. Doing so will help free up the cash necessary to satisfy the tax withholding.
With RSA plans, you’ll want to consider the likelihood of meeting the vesting condition and decide whether filing an 83b election would help you minimize your taxes.
Because you only have 30 days to file the election, it’s important to think about this decision proactively. Your Sensible Financial advisor can work with you to think through the benefits and potential risks of your decision.
 Ordinary income in this case is calculated by multiplying 1,000 shares by the price at vesting of $150.