Restricted Stock Units (RSUs) are a common form of compensation for many tech workers, especially at large public companies. But options are also common, and they generally come in two forms; non-qualified stock options (NSOs) and incentive stock options (ISOs).

Take a look under the hood of each of these types of equity. Whether you are compensated with these now or are contemplating a switch to a startup or pre-IPO company that has options when you're used to RSUs (or vice versa!) this video breaks down pitfalls and benefits of each form of equity.

Transcript:

On today's video, we're going to talk about the taxation of RSU's restricted stock units and compare that to the taxation of stock options. I'm Chris Kaminski, co-founder and partner here with Consilio Wealth, where we specialize in working with tech professionals at Amazon, Microsoft, Meta, and Google.

If work at a big tech company, likely get restricted stock units or RSUs as a part of your compensation package. These are granted on hire and also during your annual reviews and they vest over a period of years. Typically anywhere from two years to five years, but that ranges depending on the company that you work for. It's important to note that the taxation of those RSUs only happens at vest. Also, it's important to understand that when these shares vest, they are taxed just like income.

So, it's just like receiving salary or receiving a cash bonus. Let's say that when you join your company, your on-hire stock grant is 4,000 shares and at the time of your hire, your company stock is trading at $250 per share. That's a total grant value of a million dollars. Let's say hypothetically these shares vest equally over four years. In the first year, it's a one-year cliff vest, meaning 25% vest at the end of year one and then for the remaining three years, one quarter, vests each year.

So you're going to have four year vests equal parts, but a one year cliff of 25%. And then you're going to go quarterly after that point, equivalent of 25% per year. So, six and a quarter percent every quarter.

Thereforward, how does this work tax wise? So, at the end of year one, 25% or a thousand shares in this example, is going to vest. Now let's say that when you join the company, it was at $250 a share. Let's say that at the day of that first vest, it's at $300 a share, a thousand shares times $300 a share is $300,000. So, boom, that's going to vest. That's going to create $300,000 of ordinary income on the day of that vest, again, based on current stock price and the number of shares that vest.

Now, pretty much every company out there is going to have what's called a sell to cover election that's going to default at 22% for federal taxes. That means that 22% of your shares are going to automatically be sold to pay for federal taxes.

You're also going to sell a few more percent for things like Medicare tax, Social Security tax, and other just general payroll taxes. So, let's keep this simple and let's say to start out on that first vest, 30% of those shares are automatically sold and withheld for taxes and sent into the government. 22 % federal and the rest are other taxes. So, a thousand shares vest, 700 shares are actually what lands in your account and if you go into the transaction detail, you're going to see an auto sale for that 30% to go in to pay for taxes.

Now the biggest red flag here is for many of our tech clients who are high income earners, they have a big tax bill at the end of every year, 22% withholding is nowhere near enough tax. Now you don't have to worry so much about how if you're in say the 35 or the 37% tax bracket, do you need to withhold all your income at 37%? No, because each progressive dollar that you earn is taxed at that next higher bracket.

So, for example, the first say $100,000 that you earn is taxed at maybe an average of 12% not actually at 37%. So, what's important to understand here is what is the average amount of tax that you owe and then try to set yourself to cover election to the appropriate amount. You can do this at various locations depending on what company you work at. At Amazon, you can find this at amazonstock .com. Note that your trading window has to be open and also note that there's a drop down menu where you're going to change your US federal tax rate that you're going to want to elect all current and future grants. That'll just default everything in the future as I'll link to a separate video that we did on that specifically.

At Microsoft, it's a little bit different. You're going to go into the page where you see all your stock in your rewards page. On the top left-hand side, there's going to be a little pencil and the pencil is going to allow you to change your withholding amount.

At Meta, for example, you make this change in your workday portal. So, every company is a little bit different and some companies in fact don't even allow you to change the withholding. You're stuck at 37%. One other unique tax rule, supplemental compensation, which is anything that you receive outside of your base salary.

So that could be a cash bonus and that could be a stock vest. Supplemental compensation totaling over a million dollars in a calendar year is automatically withheld at 37%.

So, the way that this works is below a million dollars of supplemental compensation, you're going to be at the default 22% rate if you can't change it. Above a million dollars of supplemental compensation, you're going to then kick to the 37 % bracket. Again, it's worth noting that if you're only withholding 22% from start to a million dollars of compensation and then 37% above a million of compensation, this is still going to be far below what you need to be doing and you're going to owe a big tax bill and probably a good size tax penalty as well.

Work with a CPA or a competent financial planning firm like us who can help you predict your tax bill and send in appropriate quarterly taxes to reduce the penalty or get rid of the penalty completely.

All right, year two of RSUs, now you drop into quarterly vests. Depending on where the stock price goes, that's again going to change this taxation. So, let's say it goes to 350 a share.

Let's say it goes back down to 300 a share.

Let's say it goes to 200 a share.

Whatever the stock price is on the date of that vest times the number of shares that are vesting is what creates income. This is a little bit difficult to predict as you can imagine because stock prices are somewhat volatile. So, when we're running a tax projection, we just have to make some assumptions on what the stock prices is going to be throughout the year of which we have no prediction on. We typically just assume today's stock price, but we know that we're going to be wrong in that. Our hope is to help our clients be less wrong in these predictions and get a little bit closer to what they actually owe. One more thing on RSUs. Once you have vested those RSUs, you can sell them immediately and you won't owe any additional tax.

Now disclaimer here, if you're only withholding 22% for federal taxes and you sell them immediately and you actually owed 30%, you're going to owe more tax.

But I say this because there's a common misconception that when your stock vests, you must hold it for a year in order to receive long-term capital gains treatment. This makes no sense. If it vests at $300 a share and you sell it at $301 a share, even if you hold it for 11 months, you're only going to pay short-term capital gains on that $1 of gain.

So, the price at which it vests is very, very important. If it vests at $300 a share and in 11 months it goes to $400 a share, you might consider holding that until after 12 months one year and one day or beyond, because then you would receive long-term capital gains treatment on that $100 of gain.

So taxation is set both on Vest and then that starts to clock for long-term capital gains as well. Anything after one year is long-term capital gains but all of this is really just hinging on the stock price at Vest and the stock price at sale.

Let's shift over to stock options. There are two types of stock options, non-qualified stock options and incentive stock options and NQSOs. With non-qualified stock options, you also have a vesting date. So, you could have the same example that I had before, 4,000 shares, vesting quarterly with a one-year cliff.

So, you'd have thousand shares drop in at the end of that first year. What is unique about stock options is that there's no taxation upon vest. There's only taxation upon exercise. So how does this work? So, let's say that at end of the first year, you had a thousand shares vest and your strike price, which was the price that you got on your initial grant was $250 a share. So, I have a thousand shares that vested at $250 a share. If the share price is at $300 on the time of my vest, I can exercise these shares can buy them at 250. So, a stock option is the right to buy shares at a set price within a set amount of time. So, I have the right to buy those shares at 250 and I can immediately sell them at 300. This would make sense because I would pocket the $50 gain. If I bought my shares and I chose to hold them I would have $50 of ordinary income.

So, the way that taxation works on non-qualified stock options is it's on the difference between the strike price, the $250 a share, and the fair market value. In this example, $300 a share. So, I would pay $50 a share times a thousand shares would equal my ordinary income that I would have to pay to exercise those shares. Then from the date that I choose to purchase those shares, long-term capital gains clock starts. The important distinction here is that regarding upon vest, taxation is immediate and that immediately sets your cost basis.

A stock option, a non-qualified stock option, taxation is not immediate and it is only triggered when you choose to exercise your shares. Now, in addition to this, if the share value is lower than your strike price, you're not going to exercise. Let's say that the share price is at $200 a share and your strike price or your purchase price is 250. You wouldn't buy at 250 only to sell at 200. You lose 50 bucks. With an RSU, however, if it vests at $200 a share, you still get the money.

So, it's important to know that options can expire worthless if the stock price is trading below your strike price and this is a risk with options. This is generally why employers will give you far more options than RSUs. RSUs are guaranteed money so long as you're there and so long as the company's in business, options are not.

Okay, lastly, ISOs, incentive stock options. Incentive stock options are similar to non-qualified stock options in the sense that when they vest, there's no taxation that happens. However, what's unique with incentive stock options is when you exercise, ordinary income is not calculated. So same example from before. Let's say that I have a thousand shares vest at $250 per share. That's my strike price. And let's say that the fair market value is $300 a share. When I exercise my ISO, I am choosing to buy at 250 and I could sell at 300. Now, when I do that, and I exercise that $50 is not deemed as ordinary income.

It is however, an ad back for AMT, the alternative minimum tax, which is something that we'll discuss in another video. If you have a very large amount of ISOs that you're exercising, you could trigger AMT and you might have to pay that.

That's because the difference between the strike price and the fair market value in an ISO contributes to something that's called phantom income and if you have a lot of phantom income, let's say for example, your base salary is 250,000 and you exercise a million dollars worth of phantom income in ISOs, your taxation is going to be run on the regular schedule at $250,000 salary and on the second AMT schedule at $250,000 salary plus a million of this phantom income and that's going to show a much, much higher income, which is going to trigger AMT so there's a risk of triggering AMT with ISOs.

Okay, some additional rules on ISOs. In order to receive the most favorable tax treatment, you're going to want to not sell your shares before two years from your grant date or one year from the exercise date. If you sell before that, so let's say my grant date is exactly a year ago today, and let's say that I exercise and I sell my shares right now. I will have a disqualifying disposition and that will disqualify my ISOs and treat them like non-qualified stock options, which makes the gain from the strike price to the fair market value, all taxable income, because it's a disqualifying disposition.

So, it's important to follow the rules on ISOs and again, don't sell your shares before two years of grant or one year of exercise.

Some final thoughts. RSUs are guaranteed money. I use that word lightly. Nothing is guaranteed. Your company could go out of business. However, an RSU will vest at whatever the current market price is, whether that's $250, whether that's $50. You'll have money when those shares vest, and that's important. A pro anicon is that as those RSUs vest, you're going to have taxation. That's a pro because you have a little bit of taxation each year as the vests happen and then you're to have capital gains on the rest of the sale, assuming you hold for more than one year or if you sell very close to the vest price.

The downside is you're going to have that tax every single year and you can't control it. A pro to options is that you can control your taxation. So, you can have all these options, vesting, investing, investing over many, many years, and you could choose not to exercise them, which would keep your tax bracket incredibly low and then in one year, you could just choose to exercise all your shares. You'd obviously spike your income, but strategically, that could be the right thing for you to do and then of course that's going to fall into the roles of non-qualified stock options or incentive stock options depending on how the taxation is actually going to work.

Last thing on options, they're going to have an expire date. Typically, it's 10 years after the grant date. So, if I'm granted those 4,000 shares today, I have 10 years in order to exercise those shares. Typically, a vest period might be say four years. So, I'm going to be fully vested after four years, but then I have another six years after that vest date to actually exercise and buy my shares. I could exercise, buy, and sell. I could also exercise and hold.

Okay, one actual last thing on options. Most of the time, your company will offer you the option to do what's called a cashless sale. Cashless sale is you're choosing to buy your shares, but you don't have the money to put forth to buy at the strike price. Let's say that I have a thousand shares, vesting at $250 a share and the stock price is currently trading at $300, a share but what if I don't have a thousand shares times $250 just sitting in the bank. So, I can't come up with the cash to go and buy my shares and I'm just trying to immediately sell them at 300. The broker behind the scenes, whether that's Carta or E-Trade or any of these, they will offer you a cashless sale, which think of that as like a one second loan.

They're loaning you money to be able to buy your shares, then they're immediately selling it at that strike price, and then they're subtracting out the purchase price from the proceeds of the total transaction. That's what's called a cashless sale.

Most of the time your employer will offer you to do this and the further and further the fair market value goes from the strike price and the more shares that you have, the more cost prohibitive it's going to be in order to actually buy and hold your shares because of the sheer cost in buying and also the sheer cost of the tax of the difference between the strike price and the fair market value.

Okay, that was a lot on options. We covered RSUs, non-qualified stock options and incentive stock options. Reach out if you have any questions or specific to your plan.

We help people with this stuff all day.