Before we jump into a discussion about how many of your restricted stock units (RSUs) you should sell following each vesting date, let’s first reframe the conversation to address a misconception that I think sends many people down the wrong path right from the starting line:
RSUs and stock options are classified as equity compensation. While it might seem like a very minor nuance, I specifically tell my clients that these assets are “compensation in the form of equity”. What is the point of this wordsmithing exercise you may ask?
I believe that placing “compensation” at the front of the train (rather than equity) reframes the conversation in such a way that you are less likely to fall into the trap of saying “all smart investors know that you should hold your investments for at least 12 months to get a long-term holding period”.
You expect to be taxed on your salary (compensation) during each pay cycle, and you should also expect the same for the compensation that your company pays you in the form of RSUs.
The simple reality that many people overlook is that you incur the full tax liability the moment your RSUs vest. A quick example:
# Shares Vesting x Current value of the stock = W2 income
1,000 $50 $50,000
Your taxable income increases by $50,000 as soon as the shares vest and are released into your brokerage account. If you chose to sell these shares 10 seconds later, your short-term capital gain/loss would be limited to the negligible share price movement that occurred in those 10 seconds of ownership.
If you takeaway nothing from this article aside from the following 2 statements, you have still taken a big step forward in understanding your RSUs:
There is no tax reason to hold RSUs after they vest. The decision is purely an investment decision and should be made in the context of your goals, risk appetite, and broader financial plan.
Holding your vested RSUs is precisely the same as taking your bi-weekly paycheck (i.e. your salary) and using 100% of it to buy your company's stock.
With this context in mind, let’s review 3 primary strategies for managing your RSUs:
1 - The ‘Rational’ Choice: Sell All RSUs Immediately Upon Vesting
I’m hoping that you had a less violent reaction to this proposed strategy after reading the intro and example above than you otherwise would have, but I suspect many readers are still far from avid fans of this recommendation, so let’s dig a little deeper. What are the compelling reasons to liquidate your RSUs shortly after they vest?
Diversification trumps conviction: You have likely heard one or more of the common quotes related to diversification (i.e. all eggs in one basket = bad things can happen). It’s important to remember that your salary, annual bonus, and employee benefits are already living in this one basket. By holding onto all your RSUs, you’re also placing your longer-term goals and lifestyle aspirations in the same place.
Additional ‘compensation in the form of equity’: If you’re working in the tech industry, a very common compensation structure is to receive annual ‘refresher’ grants (in addition to a large hiring grant that got you on the ship in the first place). If you stay with the same company for several years, you “stack” these grants and the number of shares vesting annually increases. Vesting schedules are commonly 3-4 years. This means that even if you do sell all shares as they vest you still have a large pot of gold at the end of the vesting schedule rainbow in your unvested shares. If you also participate in your company’s Employee Stock Purchase Plan (ESPP), there is an additional pile of money tied to your company’s stock and upside potential.
There’s no reason to feel like you’re completely ‘selling out’ and giving up on any future upside in the stock. If the share price doubles by next year, you’ll be celebrating alongside your colleagues even if you stick with a strategy of selling all RSUs as they vest.
One exception to this argument is if you find yourself in a situation where you received a large hiring grant with no expectation of future refresher grants. In this case, you may very well want to hold onto some of your RSUs, but you still need to decide what portion of your wealth you are comfortable keeping in one stock.
As much as I believe that liquidating all RSUs upon vesting is the optimal choice, I also recognize that for many people it’s just not a step they are willing to take. The fear of missing out (FOMO) is too great. As an insider, you feel like you have better visibility to the direction of the company than the average investor. You read stories about administrative assistants working at Microsoft in the early days becoming overnight multi-millionaires. Even if you recognize the risk, you have doubts about how you would reinvest the money….S&P 500 index fund? Blah.
I get it, so let’s look at some other RSU strategies.
2 - The Riskiest Choice: Hold all your RSUs for the long-term
If you decide to hold onto all your RSUs, you are choosing to concentrate your wealth. This is the polar opposite of diversification. Depending on your situation, this might be perfectly appropriate. The wealthiest people on the planet (think Jeff Bezos, Elon Musk, and Warren Buffett) achieved their massive fortunes by concentrating their wealth in the companies that they founded and run.
I consider the following to be requirements before even considering a highly concentrated position in any one company:
A large cash reserve: By having your emergency fund in place, you reduce the likelihood that you would ever be compelled to sell your stock at a time when the market price is in a steep decline. Even if the share price is doing just fine, as an active employee you will be subjected to insider trading restrictions and blackout periods (typically centered around the release of quarterly earnings). If you have a liquidity need that coincides with a blackout period, having a cash reserve can be a lifesaver.
Retirement and “must have” goals are well funded: The idea here is you shouldn’t be putting your basic living needs or your child’s college education at risk while you’re swinging for the fences with your company stock. It’s less extreme, but it’s the same premise as that which says you shouldn’t be buying lottery tickets with your grocery budget or mortgage payment. In all likelihood, Bezos and Buffett had saved diligently for decades and weren’t risking their house or their ability to put food on the table when they began concentrating their wealth in their respective companies.
Capacity for risk: This is generally tied to the investment horizon that you have before you would need the money. If you intend to use the proceeds from your RSUs to buy a new car or make a down payment on a house next year, you really don’t have the capacity to accept the risk of holding the shares even if you’re perfectly comfortable with market volatility. I always urge clients to assign goals to any buckets of money they have. This is easy with the 401k (retirement) or a 529 account (education). Taxable savings requires some additional thought. If you don’t have a specific goal in mind, I suggest you label this bucket of money as your Opportunity Fund. Having a goal enables you to have at least a tentative timeline and a timeline informs you on an appropriate investment allocation.
If your cash flow situation is relying on some portion of your RSU income to make ends meet (i.e. your living expenses and debt obligations exceed your base salary take-home pay), you don't have the luxury to simply hold your RSUs in pursuit of long-term upside.
3 – The Compromise – Sell enough shares to at least cover the taxes
As we discussed at the start of the conversation, your RSUs are fully taxable on the vesting date. I think the official term here is constructive receipt. Even if you didn’t sell and receive the cash, you have full control over the shares once they vest. As far as the IRS is concerned, you have received the benefit of ownership and therefore must pay Uncle Sam.
But aren’t taxes withheld when the shares vest?
Yes, your company will withhold for taxes, but RSUs are classified as supplemental wage income and per IRS rules, they will withhold at a 22% statutory rate (for Federal taxes) while your actual marginal tax bracket is likely higher. If income exceeds $1MM, the withholding will be 37%.
Here’s a quick calculation to determine the number of shares to sell to cover your Federal taxes which you can apply to your unique RSU situation:
|A||# Shares Vesting||1,000|
|C = A x B||W2 Income||$200,000|
|D||Statutory Withholding Rate||22%|
|E = A x D||Shares Withheld||220|
|F = A - E||Net Shares||780|
|G||Marginal Tax Rate||37%|
|H = G - D||Incremental Rate||15%|
|I = C x H||Incremental Tax $||$30,000|
|J = I / B||Shares to Cover||150|
Note: Unless you live in a state with no income taxes (WA, TX, FL, etc), your actual withholding will include both the 22% (Federal) plus the prevailing rate in your state of residence. In California, the total withholding will typically be approximately 40%.
Selling to cover and setting aside the cash in a savings account is a great routine to follow if you are vesting RSUs on a regular basis. Not only does it reduce the concentration risk in the company stock, it also helps you to avoid an unpleasant surprise at tax time next April. Depending on the size of your RSU income relative to your total income, it's possible that you should be making quarterly estimated payments to avoid an underpayment penalty.
Whether you decide to embrace the virtues of diversification and sell all vested RSUs or you opt for the compromise and sell just enough to cover the tax liability, it's important to clarify that these funds should be placed in a safe location like a regular savings account. Turning around and reinvesting these proceeds is defeating a lot of the benefit of selling the company stock in the first place. Yes, you reduced the concentration risk, but the tax liability is not that far away. When you have an incurred tax liability less than 12 months away, safety of principal takes priority over rate of return.
It goes without saying that the 3 strategies listed above are not an exhaustive list of possible strategies, but hopefully we have identified the “goal posts” in terms of the extremes on each side of the risk/return spectrum as well as a happy medium that enables you to cover the worst case scenario while still maintaining a large position in your company stock.
If you would like an independent second opinion on your RSU strategy or need help estimating your tax liability, click HERE to schedule a complimentary consultation.