Restricted stock units (RSUs) are straightforward compared to other forms of equity compensation.
But don’t let the simplicity of RSUs cause you to look past savings opportunities. For a basic refresher on restricted stock units, start here. RSUs are gaining popularity as a form of stock compensation, which raises the importance of planning for them.
This post will cover restricted stock unit strategies that can potentially reduce your tax bill and keep more money in your pocket.
Contributing to an employer’s 401k or other pre-tax accounts reduces taxable income in the current year. If you aren’t maxing out contributions and have restricted stock units that vest in the current year, there is a planning opportunity. Since RSUs are subject to ordinary income tax upon vesting, you can use the proceeds of fund pre-tax accounts. What pre-tax accounts can be utilized?
Using RSU proceeds to fund pre-tax accounts essentially serves as a tax offset. This is because the tax liability on vesting RSUs is balanced by the tax reduction when making pre-tax contributions. Let’s look at how this works in real life.
This year, Cassie has 1,000 RSUs that vest. She is in the 24% tax bracket and contributes $9,000 a year to her employer’s traditional 401k. When the RSUs vest, they are worth $10.00. This means the vested amount is $10,000 (1,000 RSUs X $10.00). The tax liability at vesting is $2,400 (24% tax rate X $10,000). Since Cassie contributes $9,000 to her 401k, she still has room to increase her contributions up to the limit of $19,500 for 2020 ($26,000 for those age 50+).
In this example, Cassie sells the shares immediately after vesting and uses the money for cash flow needs. At the same time (or earlier in the year), she can increase her employer contributions by $10,000 (the amount of the vesting RSUs). This nets a tax reduction of $2,400 (24% tax rate) on the additional $10,000 401k contribution. While she has a tax liability on the vested shares, she gets a tax reduction with the 401k. She has essentially used the RSU proceeds to fund her employer’s 401k, which offsets the tax owed.
You can use this same strategy to fund a traditional IRA (if eligible for pre-tax contributions) and/or an HSA. Selling the shares immediately to fund other accounts diversifies the risk of concentration by reallocating to new investments.
Planning Tip: You can also fund a Roth IRA with the proceeds from RSUs. You won’t get a tax reduction upfront, but the funds grow tax-deferred and are tax-free in retirement. If you are over the income limits for a Roth IRA, you can use your employer’s Roth 401k or the backdoor Roth strategy.
If you’ve already paid tax on vested restricted stock units in previous years, this might be for you. Once RSUs vest, the stock becomes subject to short and long-term rates. Holding the stock for more than a year after vesting, any gains above the basis (vesting amount) are taxed at long-term rates. Capital gains are more favorable than ordinary income rates. These are 0%, 15%, and 20%. Most people will land at the 15% rate. If you are a high earner, you may pay an additional Medicare surtax of 0.9%.
Because ordinary tax rates are higher than long-term gains rates, you can potentially sell shares at long-term gain rates and use the proceeds to fund pre-tax accounts. Similar to the example above, except this time using proceeds from shares held long term. Let’s again look at a real-life example.
Cassie’s 1,000 RSUs vested 3 years ago at $10.00 per share, and at the time, she paid ordinary income tax. The $10.00 is her basis. The stock is now worth $30.00 per share resulting in a long-term capital gain of $20,000 ($20.00 gain X 1,000 shares). This results in a long-term gain tax of $3,000 ($20,000 gain X 15% long-term rates) when she sells.
Assume Cassie is contributing $9,000 a year to her 401k, she can increase her contributions by $10,500 to max out her 401k at $19,500. If she is in the 24% tax bracket, she gets a tax reduction of $2,520 ($10,500 X 24%). This nearly wipes out her long-term gain tax liability. She has a long-term gain tax of $3,000 but gets a tax reduction on the increased 401k contributions of $2,520. Further, she could eliminate the tax owed today on stock sale by contributing additional money to an HSA and/or an IRA if she can make pre-tax contributions.
In this example, she doesn’t have to sell all the shares. Instead, she could sell the amount she wants to contribute to pre-tax accounts. By doing this, she can reduce shares of stock and diversify investments.
What if you max out all pre-tax accounts? Then bunching deductions might be next to consider. The majority of people use the standard deduction after the Tax Cuts and Jobs Act increased it. Bunching deductions means getting as many deductions in one tax year. In other words, bunching two years’ worth of deductions in the same year to get more than the standard deduction. This is known as itemizing.
If you know a large amount of RSUs will vest in a certain year, it might make sense to plan a bunching strategy proactively. These increased deductions will help minimize the tax blow from vesting restricted stock units.
Some of the most common itemized deductions to bunch are:
Property taxes. This deduction has a cap of $10,000. To do this, you could pay next year’s property taxes before the year is over. As long as you have the tax assessment beforehand. The idea is to get two years of property tax deductions in the RSU vesting year.
Charitable donations. If you donate to charity each year, consider making two years of donations in the same year. If you aren’t sure which charity you want to support before the year ends, you could use a Donor Advised Fund (DAF). A DAF allows money to be invested to distribute later to a charity of your choice. The tax deduction counts in the year you contribute money to the DAF.
Medical expenses. If you have high medical expenses in a year that exceed 10% of adjusted gross income (AGI), you could prepay upcoming medical expenses before the year ends. This will bunch the expenses within the same year to increase deductions.
Planning Tip: You can bunch as many deductions that apply in the same year.
The next restricted stock unit strategies offer more of a hedge rather than tax savings but can still defer your tax bill to a future year. The options market is very complex, so I’m going to keep this section short. My professional advice is to seek assistance from a trusted financial advisor who has experience with options. I have a deep background in options and derivatives, so let’s chat if this is a strategy you want to explore.
Option strategies are also useful when you cannot sell shares due to restrictions or don’t want to sell shares right away.
Buying a put option gives you the “right” to sell stock at a price below the current stock price. The price level of an option is referred to as the strike price. This sets a protective floor on the stock price without having to sell it immediately. The put option reduces downside exposure but also reduces upside by the cost of the option. The cost of the option will depend on how close the strike price is to the current stock price.
A covered call is a popular options strategy where you sell a call option against shares you own, typically above the current stock price. When you sell an option, you receive a premium or money upfront. This caps your gain on the stock but generates income in the amount of the premium. When selling a call option, you are “obligated” to sell the stock if it’s above the strike price at expiration. If the stock is not above the strike price, you keep the premium as income.
Restricted stock units are a valuable part of a compensation plan. It’s important to plan ahead and have a strategy in place to guide decisions along the way. When implementing any of these restricted stock unit strategies, it’s wise to consult with your CERTIFIED FINANCIAL PLANNER™ first. There are many moving parts, and you want to get it right. If you need help maximizing or exploring restricted stock unit strategies, let’s talk!