Expanding the Benefits of Restricted Stock

Andrew Busa:

In part two of our conversation around equity compensation, we’ll be focusing on restricted stock, how it fits into your financial plan, and how to make sure you’re taking full advantage. Hi, this is Andrew Busa, a senior financial planner at Adviser Investments. We’re here with another The Adviser You Can Talk To Podcast. Today I’m joined by my colleague, JonPaul McBride. He’s a member of Adviser’s financial planning team, and he’s also an equity compensation associate. Good to have you along for this episode.

JonPaul McBride:

Good to be here. Thanks, Andrew.

Andrew Busa:

This is part two of our series on equity compensation. Today’s episode is focused particularly on RSUs, or restricted stock units, and generally some other types of restricted stock as well. I feel like as we’ve done plans over the last couple of years, JP, we’ve been seeing this item pop up more and more. Would you say that’s fair to say?

JonPaul McBride:

Definitely, definitely. We’re seeing this as one of the main forms of equity compensation, and we’ll go into the reasons for that as we get deeper into the podcast here.

Andrew Busa:

Absolutely. Here’s the structure of today’s episode, and it’s going to be similar if you’ve listened to our last equity compensation episode. It’ll follow a similar outline. We’re first going to identify two types of restricted stock and what makes them distinct. Next, we will, of course, talk about how they’re taxed, because it doesn’t matter what you get. It only matters what you’re able to keep.

JonPaul McBride:

So true.

Andrew Busa:

Exactly. And then the third and final thing we will leave you with is three ways to make sure you’re fully utilizing and maximizing the restricted stock that you do receive. That’s the outline, JP. Any other thoughts before we dive into the meat?

JonPaul McBride:

No, let’s do it.

Andrew Busa:

All right. Identifying two types of restricted stock. Let’s start there. We previously discussed, on the last episode, non-qualified and incentive stock options. How is restricted stock different from those types of equity compensation?

JonPaul McBride:

That’s a great question. There are a few things that make restricted stock different from stock options. Generally, there’s less flexibility is the first thing. Right? You can intuit that from the terms. There’s options, and then there’s restricted stock. Restricted stock is more like getting paid in equity and you truly don’t have a choice on when it comes in, as opposed to options, which you can actually exercise strategically. In that same vein, another distinction is that restricted stock is actually much easier for the company to track. This is again why it’s a little bit more common, right? It’s that it’s better for the company, it’s easier for them. You get the stock as a paycheck and they don’t have to worry about you exercising all the rules there, something going wrong, something going bump in the night. It’s just there for you, and you have no choice in the matter.

Andrew Busa:

Yeah. So, a couple of things I take from that. First, love that you point out so much is in the name of these things. Restricted versus options. That sets it up for you, how you should start to think about how these are different. Restricted stock, you just have less choice, less flexibility. And also the simplest way to think about restricted stock, like you said, is basically part of your paycheck, and we’ll get into more in terms of how it’s taxed and all of that. But that will lay a good foundation for you if you take anything from this episode. Those two things are probably some good takeaways for you.

JonPaul McBride:

Exactly, exactly. And I guess there’s one more big difference here, and that’s that restricted stock generally does not have an exercise price. As you remember, Andrew, we talked a lot about that in the last podcast, about the options. That’s one of those big things. How much do you pay for this? Or how much will you pay for this stock when you exercise or purchase it? Generally for restricted stock, it’s a $0 exercise price. So you’re paying taxes on maybe the whole spread. And that’s really kind of a big difference, a big thing to keep in mind when we’re talking about restricted stock.

Andrew Busa:

Yeah, for sure. And if you don’t remember, exercise and what that means is when you go ahead and actually purchase a stock option. In a sense, what you’re saying here is that since the exercise price of restricted stock is $0, well, just to start to think about what that means from a tax implication standpoint. If you own something at $0 per share, later on, when that vests for you, that’s going to be a spread between zero and whatever the price is when it vests. That’s going to be taxed as ordinary income. That will lay a good foundation for when we get to the tax bit of this episode. All right. Those are some differences between restricted stock and options. What are some common-ground areas that we should be aware of?

JonPaul McBride:

Well, you just mentioned one, right? And that’s vesting. Vesting schedules—just like NSOs and ISOs— usually you have to wait to meet the terms of the grant before you receive that restricted stock and the full value of that restricted stock. There could also be performance incentives as well, or performance metrics that year that you have to meet to get your restricted stock to vest. Like exercising an NSO, when you have restricted stock, the company will generally withhold your taxes right at the 22% level. That’s another thing that’s similar to what we’ve seen before. That 22% federal rate, any applicable state taxes. And also, of course, the 8% or so, 7.6%, 5% or so for FICA, which is Social Security and Medicare. The last thing I’ll say is it’s similar—there’s some opportunities here for favorable tax treatment. Even though restricted stock has less flexibility, there’s still some wiggle room, if you will, on how to get a really good tax treatment on some restricted stock.

Andrew Busa:

That’s a good segue into the next section. You mentioned that there’s different types of restricted stocks, specifically two types. And we tease that a little bit at the beginning of this episode. Give us some background here of the different styles of restricted stock.

JonPaul McBride:

Well, high level, there are basically restricted stock awards and restricted stock units.

Andrew Busa:

I feel like, personally, I’ve seen RSUs more frequently.

JonPaul McBride:

Yeah. They’re really common, right? I mean, we’re seeing these all the time. When we’re looking at our planning software, it’s very common for younger workers in their 30s, their 40s, even into their 50s and 60s to have this kind of compensation coming into their balance sheet, being a big part of their overall financial picture. Let’s take an example. And before I do that, let’s just say the basics of the restricted stock units, or RSUs, is they’re a promise to pay the shares to you—the shares or the cash equivalent of the shares—to an employee once either performance conditions are met or the timing, the vesting conditions are met.

JonPaul McBride:

So as long as you remain with the company, you should receive your RSUs. As you mentioned, an example of this. We’ve got Jan, who’s received a grant of RSUs from Amazon. Like we mentioned before, right? $0 exercise price, vesting over time. Let’s say she got 2,000 shares of Amazon granted on January 1, 2020, and they vest annually in four equal installments starting in January of 2021.

Andrew Busa:

I feel like I have to ask what seems like a basic question. What does vesting actually mean?

JonPaul McBride:

It just means that she’s now taking possession of it. She actually owns the shares now. When she gets the grant document on January 1, 2020, and she enters into that agreement with Jeff Bezos, that’s a promise for Amazon to pay those shares out to her if she stays with the company for the time of the grant, for the vesting schedule of the grant. That’s basically the promise there.

Andrew Busa:

Got it. And that’s pretty typical. The example that you laid out is that we’ll see a vesting schedule that’s, like you said, maybe it’s annually. We’ve seen quarterly. We’ve even seen monthly that these things could come in for you. Now, importantly, let’s cover more specifically how RSUs get taxed.

JonPaul McBride:

Yeah. That is the thing, right? As you said, it’s what you keep. RSUs are taxed on the fair market value of the underlying shares at the vesting date. And it’s like ordinary income. Remember, it’s like a paycheck. In the example above, with Jan, if Amazon was granted to her at $1,000 a share in 2020 but has appreciated to $1,500 a share—we saw something like this in 2021 for her first tranche of shares—she’s going to pay taxes at that extra rate, right? Those first shares are going to be paid at $1,500 a share off that first tranche of about 500 shares for Jan.

Andrew Busa:

Got it. Let’s keep carrying this forward. The shares vested. She owns them. Now let’s talk about the other part of the sandwich here, the selling decision. What happens here?

JonPaul McBride:

Once again, this is one of those similarities, right? Just like with exercised options, Jan owns those shares now. They’re her shares. She can do whatever she wants with them. She can hold on to them. Her new basis is the fair market value that she paid tax on. That’s where the tax is so important—because that becomes your new cost basis. And then at the time of vesting, she owns it. She can sell within the year for short-term capital gains or losses or hold it for a year and a day for long-term capital gains or losses.

Andrew Busa:

Right. At that point, once these are vested, it’s just like any other stock that you would own in your portfolio. It comes down to holding period, when you sell them, what kind of capital gain treatment you get and what taxes you would pay. Generally, but not always, we will advise clients to sell RSUs as they vest. And the reason for that, if you think about it, is if you sell them pretty quickly after vesting, there’s going to be very little tax implication to that sale because it wouldn’t have much time to move by the time you own it, and then you sell it. It’s just a way to make sure that you’re diversifying your portfolio as these RSUs vest. We’ll get into that concept a little bit more as we move ahead here, but just wanted to throw that in to plant the seed. Anything else that makes RSUs distinct before we move on to the other type of restricted stock?

JonPaul McBride:

Yes. I said that there’s generally nothing that you can do to defer RSUs, but there are rare instances where you can push back the vesting and the taxes that you would incur. Right? We’ll tackle that in future discussions. It’s a little bit too complicated to go into right now.

Andrew Busa:

Got it. And that would vary from plan to plan. That would be something where we would be happy to review a plan document for you if you aren’t sure if you have this sort of flexibility. We can let you know about that. All right. Now on to restricted stock awards. We just talked about restricted stock units, so let’s put that aside for a second. How are RSAs different from RSUs?

JonPaul McBride:

In a few ways. Where RSUs are a promise to deliver shares or cash to you, restricted stock awards are really almost effectively received at the grant for tax purposes. You already owned the shares in the eyes of the IRS, and they’re held in an escrow account. That means that you can receive dividends on the stock awards, whereas you can’t on RSUs. Or it’s rare for you to receive them on RSUs. And you actually have voting rights, or you have proxy voting rights, with your restricted stock award shares—as opposed to your RSU shares, where you don’t.

Andrew Busa:

That’s interesting with the voting shares. That could have some implications for certain employees. If you remember, from our last episode, we talked about with options—typically at grant, nothing happens from a tax perspective. You’re just being granted the option to own stock at some point in the future. RSAs, not the case. There is some tax implication at grant is basically what you’re saying. Right? How are RSAs actually taxed?

JonPaul McBride:

Like you’re alluding to, RSAs are generally taxed the same as RSUs—ordinary income investing on the fair market value of the shares. With the big exception that you’re alluding to, right?

Andrew Busa:

The 83(b). Typically, we see the 83(b) in smaller early-stage companies. Again, that’s a generalization, but that’s typically what we’ll see. You’ll see why that’s the case as we go through an example below.

JonPaul McBride:

Exactly, exactly. Because you own those restricted stock award shares, right? For tax purposes, you can lock in a favorable tax treatment, especially in an early-stage company. We were thinking about the 83(b) election. It’s almost like an early exercise of an option. There are a couple of things to remember. You have to do it in written form within 30 days of the grant, so there’s a ticking time bomb here, right? You’ve got to pay tax on the fair market value at the grant date, and that becomes your new tax basis. And then you don’t pay further tax, assuming that you meet all of your conditions of your grant, until you sell at capital gains rates later on. So, if you hold it for a year and a day (or even [sell sooner at] short-term capital gains rates, but most likely not), that’s when you actually sell, that’s when you’ll incur the next tax hit, and it should be at a favorable long-term capital gains rate.

Andrew Busa:

Okay. We’ll tackle an example in a second. To simplify it, the 83(b) is basically a bet that you’re making that your company is going to do very well in the future. You’re basically saying, “I’m going to lock in taxes right now with this election and then hope that this stock just goes to the moon.” Then guess what? You’ve already paid taxes on that stock. Is that a fair way of putting it, do you think?

JonPaul McBride:

Completely fair. You really are betting on appreciation. You’re betting on pretty big appreciation, right? Because you think that there’s going to be a big taxable event in the future, so you want to lock in your taxes right now. Lock in a better rate right now so that you’re not paying it on potentially $2,000 a share for that, for maybe your Amazon, in the future.

Andrew Busa:

Right. And that’s what we talked about before. This is common with early-stage companies that have, theoretically, a lot of room for growth. Their ceiling is hopefully very far away, and you can experience that very favorably if you elect 83(b). We will talk about if things don’t go according to plan. There are some downsides to be aware of. But before we do that, let’s have you take us through this example you put together to make it clear.

JonPaul McBride:

Let’s take Pat this time. Pat’s at Robinhood, and she received a grant of restricted stock awards from Robinhood of 5,000 shares with a fair market value of $10 a share when she received them in January of 2020. And once again, vesting in five equal installments starting in January of 2021. In this example, Pat is going to file an 83(b) election and pay taxes on that initial grant of shares at the grant date, right? She’s going to lock in that $10 a share of taxes. Important to note, she might need some cash for this. This is something where it’s really important to look at your plan, look at your options as far as how to exercise, what you can do, especially with the early-stage company. The market might not be there. It could be still private. That’s something that you really want to talk to an adviser about before you do it, just so you know that you have enough cash to make this 83(b) election happen.

JonPaul McBride:

When the first tranche vests, Pat basically owes no income tax. But let’s say that Robinhood has appreciated to $100 a share. Well, she can now sell part or all of that first tranche of shares that she received at long-term capital gains rates. Right? It’s a year and a day. At the next open window, let’s say it’s in March of 2021. That’s always important to keep eyes on too. When can you actually sell the shares that are vesting? Then she sells out those shares in March 2021. And she’s paying long-term capital gains rates instead of paying those bigger tax bills.

Andrew Busa:

Got it. That’s an example that went very well, right? That’s the best-case scenario. Now, what if things don’t go well? We have to, of course, throw that in there. In an example where you elect 83(b) and the stock value goes down, you’ve locked in taxes for a situation where now you’ve just lost value, and now you just have a capital loss. Right? You can use that capital loss to offset other capital gains, but clearly not great. Right? You’ve elected to pay taxes on something that, if you had the benefit of hindsight, you wouldn’t have.

Andrew Busa:

There’s another possibility that’s actually even worse than this. It’s called forfeiture—the term that you might see. This happens, potentially, if you leave the company in the middle of this vesting period or if certain growth targets aren’t hit. That’s another possibility. There’s a lot of complexity here, but basically if this happens, you can’t even take the loss on that stock. Again, there’s more complexity here, but forfeiture is something that you just need to be aware of if you’re thinking about electing the 83(b). It’s not very fun.

JonPaul McBride:

It’s not. And if it sounds complicated, that’s because it really is. Right? That’s when we want you to reach out. Especially with the complexity, with the time crunch that you’re under here with 83(b) elections. As soon as you can get your adviser involved, definitely a good idea. I think the big takeaways for 83(b) elections: Act fast; it’s for the folks who are big believers. The thing’s going to the moon, right? Those are the people who should be thinking about 83(b) elections with restricted stock awards. Also, stay at the company, right? Like I just said, Andrew, that’s one of the biggest risks here.

JonPaul McBride:

If you leave before it vests, now you’ve not only lost out on the gains—you also can’t take any of the taxable benefits. Also, make sure that you have the money for this. Right? You’ve got to make sure that you can pay for the stock. It should be at a pretty low rate, or the shares should be pretty affordable compared to where they’re going to be in the future, but you still need to come up with the cash for it.

Andrew Busa:

All right. We’ve covered a lot of helpful ground in this episode. Let’s leave the listeners, JP, with those three ways to maximize your restricted stock. I’ll let you lead off.

JonPaul McBride:

Well, first off, we want to make sure that your issued stock fits in the context of your near- and long-term financial goals. Whether it’s paying off a mortgage, paying down student loans, adding to a cash reserve. Whatever is your biggest need, you want to make sure that we take that into account before we come up with a strategy for your RSUs or your RSAs.

Andrew Busa:

That really leads into my number two point here, which is work with an adviser to come up with a discipline around the best time to sell your restricted stock. That key word, discipline, really needs to be emphasized here. Because as we’ve talked about through this episode, restricted stock isn’t something that happens once—if you are someone who gets it. It’s going to happen multiple times a year, sometimes every month, sometimes every quarter, whatever the case. You need to have a discipline and stick to it so that when you think about RSAs—generally you do want to hold them for quite some time to capture the full appreciation of the underlying stock. With RSUs, like I said in the early part of the episode, generally we find it’s best to sell those immediately as they vest or at the next open window, which I think will lead into your number three, final point here.

JonPaul McBride:

Yeah. It just leaves it perfectly, right? Just like with options, with all this equity comp stuff, you need to keep an eye on your exposure to the company that you’re receiving it from. You’re already getting your paycheck there, benefits there. If part of your net worth is already tied to your company, adding on a bunch of stock from the company is a huge risk. Right? You don’t want to have too many eggs in one basket. Like you said, a discipline is good. 5% of your net worth is a great target to aim for of company stock on your balance sheet.

JonPaul McBride:

It could creep up to 10% or beyond. You don’t want to incur taxes unnecessarily. You can let it creep up a little bit, but keep that 5% target in mind. And pay attention to your retirement plan too. That’s something that people forget about a lot as well. You may have equity comp and your salary, but also that company stock might be in your 401(k). Keep this in mind. You want to make sure you come up with a really good plan to pare back your exposure as efficiently as possible.

Andrew Busa:

I will leave it there with those excellent takeaways. This has been Andrew Busa and JonPaul McBride from Adviser Investments, thanking you for listening to The Adviser You Can Talk To Podcast. Be on the lookout for any future episodes that we might do around equity compensation. We might not be done. If you did enjoy this conversation, please subscribe and review our show, and you can also check us out at www.adviserinvestments.com/podcasts. Your feedback is always welcome. And if you have any questions or topics that you would like us to explore, please email us at info@adviserinvestments.com. Thanks for listening.