However, financial planning with restricted stock and RSUs can be deceptively complex for a type of equity award that is supposed to be foolproof. Plus, you have the taxes to understand. Key questions to include on your planning checklist:
- What documents have the important grant details?
- How will withholding be handled at vesting?
- Should you hold or sell the shares?
- If you sell, how many shares should you sell, and what should you do with the proceeds?
Below we present three key planning topics recommended by financial advisors (all CFP® professionals) who have extensive experience in working for clients with restricted stock, RSUs, stock options, and ESPPs. For more on these planning topics with RSUs in particular, see articles at myStockOptions.com written by two of these advisors (Sell Or Hold RSU Shares At Vesting? 3 Approaches To Consider and Financial Planning With Restricted Stock Units: 3 Key Questions). In addition, all three of the advisors were featured presenters in a popular recent myStockOptions webinar on these topics: Restricted Stock & RSU Financial Planning: Advanced Bootcamp, now available on demand.
1. Understand Your Grant And Its Documents
This point may seem obvious, but you’d be surprised. We hear from financial advisors whose clients tell them they have “stock options” but upon inspection of the plan documents it turns out they have another type of equity comp. So, first of all, confirm which type of equity grant you have: restricted stock or RSUs, separate from any stock options or an employee stock purchase plan.
While restricted stock and RSUs are conceptually similar and close siblings, they have important differences that can matter for your financial planning (see an FAQ on the website myStockOptions.com that outlines the differences).
You want to review your actual stock plan, the grant agreement itself, communications materials your company provided, and any third-party website where you can view your grant and some of the details (e.g. website of broker or transfer agent). Two core facts to know about your grant from this review:
- Vesting schedule: how many shares vest and on what dates?
- What are tax-withholding choices?
You have many other potential factors to understand. “Roughly how much will each vested amount be worth, pre- and after-tax?” asks Meg Bartelt of Flow Financial Planning (Bellingham, WA). As someone who works with clients at pre-IPO and newly public companies, she also considers the traits of RSU grants made by private companies. Is simply working at the company for a specified length of time after the grant enough for the shares to vest, or is there a second trigger involving a liquidity event (i.e. IPO or acquisition by a public company)?
Then you need to know the impacts of job events, life events, and M&A on each grant, points out Chloé Moore of Financial Staples (Atlanta, GA). “How do leave of absence, disability, death, etc. affect the vesting schedule?” is something she considers for each of her clients. Daniel Zajac of Zajac Group (Exton, PA) concurs, adding: “What if the client leaves near retirement or is seeking another job?”
2. Know The Tax Impact
Watch out for taxes, emphasize all of the financial planners. Taxation can be tricky with restricted stock and RSUs.
Section 83(b) Election For Restricted Stock
With restricted stock, the usual time of taxation is vesting. However, within 30 days of the grant date you can make what’s called a Section 83(b) election to be taxed on the value of the shares at grant instead of at vesting (election not available for RSUs). If you’re confident the stock price will significantly rise between grant and vesting, this election to pay taxes on the lower value at grant can be a good bet, and it starts your capital gains holding period early. However, figuring out whether that is a good bet is complex and risky.
Tax-Withholding Issues
Then you face the issue of under-withheld taxes. According to the IRS rules for supplemental wage income, such as income from the vesting of restricted stock or RSUs, your company must withhold tax at a flat rate of 22%. (The rate jumps to 37% for income amounts in excess of $1 million during the calendar year.)
Here’s where it gets complicated. The rate you pay in your income-tax bracket is likely to be higher than the tax-withholding amount for your grant—especially after your income spikes with the vesting of your shares. Most people with just-vested restricted stock or RSUs need to pay extra taxes to make up the shortfall, whether via quarterly estimated tax payments or their tax return for the year. Therefore, unless you have extra cash lying around for your tax bill, you need to plan how many shares you need to sell to cover the taxes.
Mistakes here can be very costly. “The worst-case scenario with RSUs, in my opinion, is that you lose money on them,” says Meg Bartelt. “And that’s a possibility if you do not sell enough RSUs immediately to pay your full tax bill.”
The concern? The stock price could suddenly fall. “The bottom line is that if the stock price drops enough after the initial withholding of 22% before you sell more shares to pay your taxes, then the shares you still have can be worth less than the taxes you still owe.”
“Get ahead of the game by preparing a projected tax return to see the impact of vesting RSUs on your tax return,” advises Daniel Zajac. “Consider ways to defer other income and/or increase deductions to reduce the spike in your taxable income,” he adds. “For example, increase 401(k) contributions, participate in a nonqualified deferred compensation plan, make bigger charitable donations, or separately increase salary withholding.”
3. Have A Strategic Plan For The Shares After Vesting
Chloé Moore of Financial Staples in Atlanta has helped many clients meet their financial goals with tailor-made strategies for RSU shares. In one example that she explained to us, her approach included:
- Allocated monthly savings, cash bonuses, and sign-on bonus to short-term savings goals.
- Kept 25% of shares that vested after the one-year anniversary (about 30% of the portfolio and a smaller percentage as the portfolio grew).
- Set aside reserves to pay the tax bill (worked with a CPA to estimate each year’s tax liability).
- Sold remaining shares as they vested and split the proceeds between student loans and savings goals, then eventually a diversified taxable account.
This is just one example of an approach when shares vest. Everyone’s individual circumstances differ. Identifying strategies that work for you is one good reason to consult a financial planner.
Concentration Risk: Don’t Keep All Your Eggs In One Basket
An important part of financial planning for just-vested shares is understanding the risks of holding them and the need for diversification. After the vesting, you could have substantial amounts of your personal wealth tied up in just one stock. We’ve all seen how quickly a stock price can tank. If you are, for example, subject to trading restrictions by your company during a blackout period, you may not be able to immediately sell shares to avert losses. With a falling stock price, all you could do in that case is watch the value plummet.
“Investments that are diversified—your money is invested a little bit in a lot of different stocks or bonds—perform better, on average, than investments that are concentrated in one stock,” points out Meg Bartelt. “Diversification is said to be ‘the only free lunch in investing.’ Keeping your company stock is anti-diversification.”
Meg often generally advises clients with just-vested RSU shares to sell all the stock. “Let’s say your RSUs are worth $100,000 when they vest. If I gave you $100,000 in cash income instead, would you go out and use that money to buy your company stock? If your answer is no, then that is literally the same, financially, as selling all your RSU shares.”
In her view, “you’re better off selling them all and using the money immediately for some current need (such as a down payment on a house) or other financial opportunity (such as paying off debt), or investing the money in a broadly diversified, low-cost portfolio.”
This is just one type of strategy. “There’s an almost infinite spectrum of decisions you could make here,” observes Meg. Holding some shares can often be more acceptable to clients, she explains.
The most important point, in her view, is diversifying and thus reducing the risks that arise from concentration of wealth in just one vulnerable stock. “Selling at least some shares is progress toward a portfolio whose risk-adjusted return is optimized.”
More Strategies To Reduce Concentration Risk
“One strategy that may balance the decision to immediately retain 100% of the shares or sell 100% is to implement a plan that sells a certain number or percentage of shares over a set period,” says Daniel Zajac.
“Setting a sell schedule allows you to intentionally reduce your company stock according to a formula,” he explains. “That removes some of the emotional decision-making from the process. You don’t need to guess what the stock price will do next, or decide you will sell when the price reaches X per share, but change your plans once the price does hit that point. You then risk the price going back down before you do sell.”
For clients who are loyal to their company stock and feel reluctant to “dump” it, a compromise approach can be highly beneficial, Meg suggests. “I find this cognitive flexibility comes in handy when I’m working with clients whose net worth is tied up heavily in their company stock. In my profession, there’s a rule of thumb that no more than 5% of your investment portfolio should be in a single stock. Often I work with clients who have 20%, 50%, 90% of their liquid net worth (i.e. cash and investment accounts) in their company stock.”
For many people in this position, selling all the way down to 5% is often “just too big a shock to the system,” Meg has learned. “But I find most people are fine going from 90% to 70%. Or 50% to 40%. And you know what? That’s progress.”
Employees with stock option grants, whether NQSOs or ISOs, face important wealth-building and tax-minimizing decisions about when to exercise their stock options. Our upcoming webinar Stock Option Exercise Strategies: Advanced Bootcamp will clearly explain the variety of stock option exercise strategies to both build wealth and prevent expensive mistakes. This webinar is part of our advanced series building on our flagship webinar Stock Compensation Bootcamp For Financial Advisors.
WEBINAR: Stock Option Exercise Strategies: Advanced Bootcamp
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