Stock options were all the rage during the dot com boom of the late 1990s. Equity compensation is still booming, and it is now more widely used than ever. However, restricted stock has become the compensation tool of choice among start-ups and tech companies, whereas stock options have become slightly less common.
Equity compensation (Stock options or restricted stock) leads to a host of financial planning questions and issues, which primarily center around understanding how it works, how to minimize the tax impact, and what to do with your employer stock once you own it.
Today’s article focuses on the basics of Restricted Stock. We will save stock options for another day.
First, if you have received a grant of Restricted Stock, congratulations! This is nice bonus. Your employer is giving you shares in the company instead of giving you cash. You can sell your shares to convert them to cash once the shares are no longer restricted.
Your shares are “restricted” because you can’t sell them until they vest. In my experience, most companies use a 3- or 4-year vesting schedule. Some companies use cliff vesting where none of your shares are vested (liquid) until the end of the period. However, graded vesting is much more common, whereby the shares vest evenly (annually or quarterly) over the vesting period.
Most stock grants vest based on time, so all you need to do is avoid getting fired to receive the stock. However, some grants vest based on attainment of pre-determined performance targets. All of this is spelled out in your restricted stock plan documents, which you and/or your financial advisor should review.
Once you own the shares outright (after they have vested), you can hold, sell, donate, or gift your stock as you wish (Note: Be careful to avoid insider trading. This means you cannot sell when you know important nonpublic information about the company. Talk to your HR department about blackout periods).
Two more notes about vesting:
- Private companies often have a second requirement before you can sell your shares, which is the company must have a liquidity event (i.e., IPO, sale, or merger). This is known as double-trigger vesting.
- When reviewing your company’s restricted stock plan document, find out the impact on vesting of unplanned events such as a sale or merger of the company, as well as life events such as death, disability, and leave of absence (e.g., maternity leave).
Restricted stock grants become taxable as ordinary income (just like wages or bonuses) when they vest. This is true even if you do not sell the shares or have any money distributed to you. The IRS requires your company to withhold taxes on “supplemental wage income,” such as restricted stock and stock options at a flat rate of 22%. This jumps to 37% for income greater than $1 million during any calendar year. You will also owe payroll taxes (Social Security, Medicare, etc.) and state income taxes (unless you live in one of the nine states that do not have a state income tax).
The withholding is typically accomplished by holding back some of the shares, so only the net number of shares (after tax withholding) are deposited into your brokerage account for you to hold, sell, or donate.
Recipients of restricted stock are often surprised when they file their tax returns because the amount withheld may not have been enough. Suppose you end up in the 32% federal tax bracket, but only 22% was withheld from your vested stock grants. You will owe an additional 10%. This can be especially distressing if the value of the stock has declined and now you need to sell a significant portion of your shares to cover taxes.
I recommend working with your financial advisor and/or CPA to make sure you have paid in enough taxes, either through the company withholding or additional quarterly estimated payments. There’s not a lot of tax planning you can do to change the fact that the stock grant became taxable. Therefore, the focus of tax planning needs to be whether you can/should defer other income to a future year. Maybe you want to defer more income into your 401k, Deferred Comp, or HSA to reduce your tax bill. If that leaves you without enough take-home pay to cover your bills, you can always sell some of your vested stock since that income is taxable regardless of whether or not you withdraw the funds.
What Should You Do with Your Vested Shares?
- Sell – Let’s suppose you received a cash bonus at work of $50,000 (after taxes). Would you invest all $50,000 into shares of your company? Probably not. So, allocate your vested shares the way you would any other bonus. Figure out how much you want to spend vs. save, and then diversify the savings portion over a range of investments designed to meet your financial goals.
It is common for recipients of stock grants to keep a substantial portion of their personal wealth tied up in stock of their company. This is risky. I would try to limit your exposure to company stock to a maximum of 10% of your investible assets. The rest should be diversified.
- Hold – The cost basis of the shares becomes the fair market value at the time they vested. (This is the amount you paid taxes on.) If you continue to hold shares after vesting, you will have a capital gain or capital loss when you eventually sell the shares (equal to the difference between your cost basis and the sales price). Many people get emotionally attached to their company shares and end up with a concentrated position out of a sense of loyalty. It may be too big of an emotional leap to cut your holdings of company stock all at once by 60, 70, or 90%, so come up with a plan to reduce your exposure over time.
- Donate – If you are charitably inclined, talk to your financial advisor or CPA about which shares to donate to get the best tax treatment. All things being equal, you want to donate shares that have appreciated since they vested. This enables you to avoid the capital gains tax associated with selling the shares, while providing a tax deduction equal to the full fair market value of the appreciated shares (assuming you itemize deductions).
I always recommend living off your base salary. You are living beyond your means if you need to liquidate your restricted stock each year to fund your lifestyle. Stock grants or any type of windfall or bonus is your chance to cover big one-time expenses (e.g., home remodel) or turbo-charge your savings. Plan wisely.
Questions? Comments? Email me to let me know how I can help with your equity compensation questions. Have a great week.