Don't Vest And Forget: Understanding RSU's Asymmetric Tax Risk
Restricted Stock Units (RSUs) are a popular form of equity compensation many companies use to incentivize and retain employees. RSUs are often granted as part of an employee's compensation package and represent a promise to deliver company stock at a future date, usually after a vesting period. While RSUs can provide a valuable opportunity for employees to participate in their company's growth, they also come with unique tax considerations, including asymmetric tax risk.
Asymmetric tax risk refers to the potential for RSUs to result in uneven tax treatment based on the stock's value at different points in time. This can occur due to stock price fluctuations and tax rate changes, which can impact the tax liability for RSU recipients. Let's dive into how asymmetric tax risk can impact RSUs.
Taxation of RSUs
Taxation of RSUs is typically at the time of vesting when the shares are delivered to the employee. The value of the vested RSUs is treated as ordinary income and is subject to federal, state, and local income taxes, as well as Medicare and Social Security taxes. The employer typically withholds a portion of the RSUs to cover the taxes the employee owes (although very commonly not enough), and the remaining shares are delivered to the employee.
Asymmetric Tax Risk
The asymmetric tax risk of RSUs arises from the fact that the tax liability is determined based on the stock's value at the time of vesting, regardless of whether the employee chooses to sell the shares or hold onto them. If the stock price increases after the RSUs vest, the employee may end up with a higher tax liability. On the other hand, if the stock price decreases, the employee will still be fully taxed on the total value of the RSUs at the time of vesting.
For example, let's say an employee receives 1,000 RSUs that vest after one year, with the stock's value at $100 per share at the time of vesting. The total value of the vested RSUs would be $100,000, and the employee's tax liability would be based on this value. However, if the stock price increases to $150 per share by the time the employee sells the shares, the employee would receive $150,000 from the sale, but would still be taxed based on the $100,000 value at vesting. The additional $50k in gain would be taxed at capital gains rates, resulting in a higher tax liability.
To better illustrate this point, let's assume the employee in question is in the 20% Federal long-term capital gain bracket, 37% Federal income tax bracket, and the 13.3% California income tax bracket (CA does not distinguish between ordinary income and capital gain income). When the $100k value of RSU's vest, the employee will owe 50.3% (37%+13.3% or $50,300) in taxes simply because the RSUs vested - no sales required. If the employee sold at the time of vesting, this would result in a final realized tax rate of 50.3%. However, let's say the employee holds the RSUs, and the stock price increases to $150/sh, and then the employee sells over a year after vesting to achieve long-term capital gains. The employee will still owe the $50,300 in taxes from the vest, yet will realize an additional $50k in pre-tax value from selling the RSUs. The additional $50k in capital gains will be taxed at 33.3% (20%+13.3% or $16,650), bringing their total tax liability to $66,950 on the 1000 granted RSUs for a total pre-tax value of $150k. This grant's final realized tax rate is 44.63% ($66,950 divided by $150,000). Even if the stock doubled in price to $200/sh, the resulting realized tax rate would only fall to 41.8%.
On the other hand, if the stock price decreases to $80 per share by the time the employee sells the shares, the employee would receive $80,000 from the sale, but would still be taxed based on the $100,000 value at vesting. This would result in less total tax liability than in the example above. Yet, the tax rate would be higher compared to the actual proceeds received - i.e., being taxed on the $100k value of the stock but only receiving $80k due to the stock price depreciating.
To better illustrate this point, let's continue the assumption the employee in question is in the 37% Federal income tax bracket and 13.3% California income tax bracket. When the $100k value of RSU's vest, the employee will owe 50.3% (or $50,300) in taxes simply because the RSUs vested - no sales required. If the employee sold at the time of vesting, this would result in a final realized tax rate of 50.3%. However, let's say the employee holds the RSUs, and the stock price falls to $80/sh, then the employee sells. The employee will still owe the $50,300 in taxes from the vest yet will only realize $80k in pre-tax value from the RSUs, resulting in a realized tax rate of 62.88% ($50,300 divided by $80,000).
If the stock halved to $50/sh, the realized tax rate would rise to 100%! Yes, this means that the employee owed as much in taxes as the proceeds they received from selling the RSUs - making the entire grant worthless to the employee.
This is the asymmetric tax risk of RSUs
As the stock price falls, one will owe substantially more in taxes as a percentage of the total value of the grant, and even risk owing more in taxes than you receive in value of the stock. As the stock price rises, your tax rate does fall thanks to long-term capital gains (if you hold it that long), but with substantially decreasing marginal benefit.
Mitigating Asymmetric Tax Risk
Unfortunately, there really is only one strategy that employees can consider to mitigate the asymmetric tax risk associated with RSUs (and it tends to be an unpopular one):
- Sell RSUs at Vesting: By selling a significant portion or all of the RSUs immediately upon vesting will lock in the current stock price and minimize the risk of potential future price fluctuations. By doing so, the employee can ensure that the tax liability is based on the actual proceeds received from selling the shares, reducing the asymmetric tax risk.
In this vein, I commonly hear from clients and friends that receive RSU compensation that they want to wait until they hit long-term capital gains rates to reduce their tax liability. What I hope to communicate in this piece is that strategy only works (i.e., is net-beneficial) if the stock price appreciates in that year's holding period but with only marginal tax rate benefit. And if the stock price goes down, it is net-detrimental at an increasing rate the further the stock falls, possibly to the point that the entire value of the grant to the recipient is wiped out. Not exactly a great trade-off if you ask me.
So, this asymmetric relationship is:
- Generally not well understood by RSU recipients.
- A very unattractive attribute with respect to any prospective investment opportunity.
- The most significant reason why the burden of proof for any specific situation lies in why one should hold their RSUs after vesting - and not why one should sell.
To wrap up, RSUs, and all forms of employee equity compensation, each have unique wealth planning impacts and considerations. Taken individually, they can be complex enough to the point of needing professional guidance. However, it is becoming more common for tech professionals to receive grants of multiple forms of equity compensation over their employment tenure. In all cases, it is recommended not to vest and forget by intentionally understanding and analyzing all equity grants and implementing a full-vesting-cycle strategy integrated with an overall wealth plan.