The last conversation you'll ever need to have about: what to do with RSU's
So I'm a bit of a fan of "last conversation"-style articles -- I was inspired by the one on "eating right" to write my own on retirement withdrawals, and since then I've bravely resisted the temptation to make every article in that style. Well, that was four years ago, so I decided to give in. If you like it, let me know on Facebook or LinkedIn, and I'll consider it carte blanche to use that style with reckless abandon.
With that out of the way, let's kick off the conversation!
Part of my compensation package is in Restricted Stock Units. What do I do with those?
Let's get the basic definition out of the way first: what, exactly, are RSU's? They're actually fairly straightforward: you're promised a certain number of shares over the course of a certain amount of time. Once they vest, the shares are yours, to do with as you wish.
So: what to do with them?
Disclaimer: everyone's situation is different, so this might not be optimal for everyone. That said, for the majority of my clients, I would recommend the following as soon as possible after vest:
Sell all vested RSU's.
If necessary, make an estimated tax payment with the proceeds.
If any of your cash buckets need immediate topping off, do so.
Invest the remaining proceeds in a portfolio that matches your risk tolerance and risk capacity.
That's it. But there's a lot to unpack there, so keep the questions coming!
If I sell them immediately, won't I be paying short-term capital gains taxes? Shouldn't I wait for a year, so they're eligible for long-term capital gains treatment?
Technically, yes, but practically, no. See, the way RSU's work is that their fair market value on the vest date is taxed as ordinary income, and the cost basis is set to that value. So if you sell them immediately, the capital gains tax will be virtually zero -- you were already taxed on that amount.
Another way to think about it is this: from a tax perspective, RSU's behave exactly as if your company gave you a bonus on the vest date equal to their fair market value on that day, and you turned around and immediately bought as many shares as you could with that bonus. So if you turn around and immediately sell them that day, it'll be virtually the same amount you bought them for, so you won't owe any additional tax.
You're saying RSU's are basically a bonus that my company decided I would invest in their stock? That seems...shady.
That's not an invalid point, but I actually disagree. Remember, the RSU's were likely granted between 1-3 years ago; by tying your "bonus" to the amount the RSU's appreciated between grant and vest, your company is allowing you to participate in their success. Sort of like profit-sharing, but for stock price, which is particularly nice when you work for a tech company that plows all of its profits back into the business. So to me it seems only fair: your company is letting you to participate in their growth, rather than keeping all of it for themselves.
(In fact, some companies that don't have RSU's use "phantom stock" and other programs to allow employees to directly share in the increasing value of the company, without actually holding ownership shares per se.)
So if I sell immediately, I shouldn't owe much, if any, additional tax -- but why do you then turn around and tell me to make an estimated tax payment?
That tax payment isn't for capital gains -- it's for ordinary income. Remember how I said that RSU's are taxed as ordinary income at the time of vest? Well, while nearly all companies do withhold some of your RSU's for taxes, they don't use the same calculations that they do for your paystub -- instead, they withhold at a flat rate. Often, this rate is 22%; if your marginal tax is close to that, then it's probably fine. But if you're in the 32% or 35% tax bracket and they're withholding at 22%, then they're way underwithholding, and you're going to end up owing a hefty tax bill at tax time. (Side note: cash bonuses work the same way! 90% of the time that Seaborn's clients owe a tax bill, it's because of this. The perils of earning big bucks...)
There are several ways to handle this, but one way is to make the estimated tax payment now (IRS Direct Pay is a good way to do so), while you're flush with cash, so you don't have to worry about it come tax time. You can also set aside money in a savings "bucket" to make the payment at tax time, but just be aware that you may owe a penalty for underwithholding if you're not careful.
How do I calculate the estimated tax payment?
One "back of the envelope" calculation is (Total RSU value at vest * (your marginal tax rate - company withholding rate)). (If you don't already know, your "marginal tax rate" is the tax rate at which your next dollar of income would be taxed -- it's another way of saying "your income tax bracket".)
There are a couple of potential issues with that, though. One is that your marginal tax rate may not be the rate at which the RSU income is actually taxed -- it may be that part of them are taxed at one rate and part at another -- so this estimate may be unnecessarily conservative.
The other is that it's often hard to actually find the total RSU value at vest -- remember, the company withheld some of that for taxes, so you only ended up with the net value. So the first time you do this, I strongly recommend you go hunting and figure out what rate your company uses for withholding. (Once you find the total RSU shares you were given, it's easy enough: (Company withholding rate = (RSU's withheld for taxes/total RSU's vested)).
Once you've figured out your company withholding rate, though, it's easy: every time RSU's vest, you can estimate the total RSU value based on the net RSU value by the following equation: (Total RSU value at vest = Net RSU value at vest / (100% - company withholding rate)).
So the estimated tax calculation would then be: ((Net RSU value at vest / (100% - company withholding rate)) * (your marginal tax rate - company withholding rate)).
That all sounds kind of complicated.
Kind of, but if it doesn't make immediate intuitive sense now, it most likely will once you've gone through it a couple times. And of course you can easily make a spreadsheet to do the math for you!
Alright, I get the tax situation. But...how do you know that "immediately after vest" is the right time to sell? Don't we want to "buy low and sell high"?
Remember what I said about how RSU's are basically a bonus that your employer decided to invest in its own shares on your behalf? If someone gave you $20K, is that really the first thing you would do -- invest it in your company's stock?
Well...yes, actually. It's a good company, and it's well-positioned in the current market, and it's just done so damn well recently!
Alright, fair enough. All of these things are factually accurate, and we'll pretend that inertia and FOMO isn't unduly influencing you. But let's take a step back: how are we building our portfolio?
If we're using a research-based factor model -- you know, the one that won a Nobel prize in 2013 -- then we're already optimizing our portfolio around the factors of increased returns: "beta", value, size, momentum, profitability, etc. Chance are high that if the company really is expected to have higher returns, then we're tilting towards it anyway -- just enough to increase our overall returns, but not so much that if this particular company falls, it'll take our financial plan with it. We've already got an optimal amount of that stock in our portfolio -- why mess with that?
To put it another way: as soon as you start making oversize bets on a particular company, you're moving from being the casino to being a gambler. And wouldn't you rather be the casino?
Moreover, even if you sell all of your RSU's immediately upon vest, you're actually still invested in the company -- not just through your diversified portfolio, but through the RSU's that have been granted, but haven't vested yet! So it's not like you're going to lose out on upside -- you're just taking some chips off the table.
Also, all those good things you're hearing about your company are almost certainly coming from your CFO, and one of their primary job functions is to convince the analysts that this stock is a "buy". A good CFO is a master of spin! (I'm not saying that the things aren't necessarily true; I'm just pointing out a fact.)
I get all of that, but I still just really want to invest in my company; I just can't stand missing out on the potential upside. Also, that stock has treated me really well over the years.
Alright, as long as you're aware of all of the things I said above. If you're going to speculate, strongly consider creating a systematic approach to your speculation and codifying it in an IPS: a document that outlines exactly what is and isn't allowed in your portfolio. While you're figuring out your plan, consider two things:
How much of your portfolio will be speculative assets? Consider no more than 5%, and no more than 2% in any given security, so that they don't become the "tail that wags the dog".
When/how will you rebalance? For example, consider rebalancing back down to your target once per year, on a particular date, again "taking chips off the table" on a regular basis.
By having a plan for when/how much you'll buy and when/how much you'll sell, you can ameliorate the emotional roller-coaster that comes with not having a plan.
And while you're thinking about all this, consider reading up on wise decisions v. good outcomes. Research is clear that the day-to-day variation in a stock is unpredictable, and therefore effectively random noise; if you can't divest your emotional well-being from the performance of your company stock, you're virtually guaranteed have a stressful time of it!
Alright -- I've got a plan for what to do with future RSU's. But...I'm kind of sitting on a pile of "legacy" RSU's I never bothered selling. What do I do with those?
This is one of those situations where Your Mileage May Vary considerably, depending on your context. But given everything I've said thus far, assuming you're not interested in speculation, the main consideration here is most likely taxes.
Let's start with the easy case: if some (or all!) of your RSU's are "underwater", at a fair market value less than their cost basis, then you can sell them off with no negative tax consequence whatsoever. If this is you, strongly consider doing so -- refer back to Answer #1 above.
If you're sitting on a bunch of "unrealized capital gains", though, then selling the RSU's will come with a tax bill. At this point, you're going to have to balance "getting rid of the hot potato" on one hand with "paying a large tax bill" on the other. I wrote a whole article on "when to suck it up and pay capital gains" that could help on this front, but there's one highlight from that article that I'll point out here: chances are very high that you're going to pay the tax on that stock at some point, and while deferring taxes does have value, tax deferral is not the same as tax avoidance! (And if you think you're the exception, read the article all the way to the end -- you may be surprised.)
At this point, it's worthwhile to start asking questions. Would it bump you into a higher tax bracket to sell it all now? Over how many years would you have to spread out the sale in order to not get bumped into a higher tax bracket? If you did sell at a higher tax bracket, how much more in taxes would you actually pay, and would that have a material impact on your financial plan? Conversely, consider the hot potato: what would happen to your financial plan if the stock Coinbase'd before you sold it all?
The answer to those questions should help you formulate a solid plan for diversifying out -- and I recommend you find a plan and stick to it, rather than just "playing it by ear". Our cognitive biases are strongly against us when it comes to selling concentrated stock positions; having a system in place is one of the best weapons we have against them!
That's fair, but -- I'd like some help answering those questions, and I don't want to sign up for someone to manage my investments just because I need some financial math done.
Luckily, nowadays there are plenty of advisors (including Seaborn, naturally) who have hourly and fixed-rate services -- we understand that sometimes you just want a simple question answered! Here's a decent place to start looking for help.
Britton is an engineer-turned-financial-planner in Austin, Texas. As such, he shies away from suits and commissions, and instead tends towards blue jeans, data-driven analysis, and a fee-only approach to financial planning.