This article was contributed by Wealth Advisor John Zachary.
If you look back 20-30 years, it was common for companies to offer employees access to company stock through company retirement plans, stock compensation plans, or employee stock purchase plans. In the fallout following the collapse of Enron and WorldCom in 2002, many employees lost not only their jobs but also their life savings as their company stock went to zero. This resulted in tremendous scrutiny from regulators, ultimately leading to legislation aimed to protect employees from corporate meltdowns.
But over the past several years, we’ve seen companies – including those here in Wilmington – add back access to company stock, in large part through stock compensation plans. These plans include stock options, restricted stock units (RSUs), and employee stock purchase plans. These plans are complicated, can differ tremendously from plan to plan, and can have significant tax implications, if you’re not careful. It is important to consult your financial professional and/or tax advisor to make sure you understand how these plans work, specific to your individual tax situation and goals.
In this two-part series, the first topic I’ll talk about is restricted stock unit (RSU) plans. In the following article, published later this month, I will discuss stock options.
RSU plans work like this: a company awards an employee with a certain number of restricted stock shares subject to a vesting period. The vesting period can be timebound (over a certain number of years), based on company performance criteria such as EBITA (company earnings before interest, taxes, and amortization), or a combination of both. Once the vesting requirements are satisfied, full ownership of the shares is transferred to the employee. In other words, the stock units have no tangible value until vesting requirements are met. Upon vesting, the employee has the option of holding the shares or selling them for profit. If you leave your company before your RSUs vest, you may be forfeiting your stock units.
As soon as a RSU vests, it is a “taxable event,” taxed as ordinary income based on the value of the stock on the vesting date. Like a paycheck or bonus, the transaction will result in tax withholding as it runs through payroll. In most cases, unless elected otherwise, enough stock shares are sold to cover the tax withholdings and the net shares are deposited into a brokerage account in the employee’s name. If the employee sells their shares immediately, the only taxes would be the ordinary income tax on the vesting transaction. If the employee holds the shares and the stock price goes up, then capital gains taxes will apply. Further, if the shares are held for less than one year, short-term capital gains tax, equal to your ordinary income tax rate, applies to any gains from the sale. Any shares sold one year or later are taxed at the preferential long-term capital gains tax rate, which ranges from 0%-20%, but for most folks is 15%. The long-term capital gains rate is typically lower than your ordinary income tax rate, giving employees a tax incentive to hold the shares for longer than one year, but also exposing them to potential fluctuations in the stock price.
Here’s a quick example: an employee gets awarded 1,000 RSUs as part of their compensation plan. The shares vest equally over a four-year time period, starting on the first anniversary of the award. After year one, 250 shares will vest. If the stock price is $15 per share on the vest date, the employee will have $3,750 added to their taxable income for that year. If there are tax withholdings, say of 20%, then 50 shares will be sold to cover taxes and the remaining 200 shares would be deposited into a brokerage account in the employee’s name. If the employee holds the shares and sells all 200 after 6 months, when the stock price is up to $20 per share, the employee will realize a short-term capital gain of $1,000 ($5 per share gain x 200 shares). If instead, the employee waits and sells all 200 shares 18 months after the vest date, when the stock price is at $20 per share, the employee would still have a $1,000 capital gain, but it would be taxed at the lower long-term capital gains rate.
As you can see, this is a complicated subject. Individuals who aren’t aware of how these plans work, and simply sell without considering taxes and their specific financial situation, may be surprised by significant tax ramifications. At Pathfinder Wealth Consulting, our wealth advisors are specialists in stock compensation plans and can help you layout a game plan for your company stock, to help make sure you avoid overconcentration but also maximize the after-tax benefit of your awards. In the coming weeks we will be holding a free webinar on this topic to shed a bit more light on the topic. For more details, please email [email protected], or give us a call to see how we can help.
Pathfinder Wealth Consulting does not provide legal or tax advice. You should consult a legal or tax professional regarding your individual situation.
John Zachary is a Wealth Advisor at Pathfinder Wealth Consulting. Pathfinder specializes in comprehensive financial, estate and tax planning services, investment management, and risk management (insurance) for business owners and successful executives. Advisory services offered through Commonwealth Financial Network®, a Registered Investment Adviser. To learn more about Pathfinder Wealth Consulting, visit www.pwcpath.com. John can be reached at [email protected] or 910-793-0616.
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