Restricted stock has become a common offering among employers in the last 20 years. There are two main types: restricted stock awards (RSA) and restricted stock units (RSU). Both can be lucrative parts of a compensation package, but they have important differences that can affect your long-term financial interests. Consider working with a financial advisor as you decide what to do with stock-based compensation.
What Is Restricted Stock?
Restricted stock is equity granted to employees as part of their compensation packages. Often these grants are made by young companies that can’t yet afford to pay high salaries, with companies granting restricted stock in lieu of higher cash compensation.
Unlike more common stock options, which give you the right to buy stock at a later date, you’re given restricted stock immediately or it’s promised by a certain date – provided you meet conditions that the company sets in advance. But even when the stock is awarded immediately, it will not vest, or become available for you to sell, until an appointed future date. Often the award will vest over a period of time, with portions of it becoming available at intervals. The upshot is that the recipient can’t, for instance, sell the shares and pocket the money before vesting. The recipient also may not be able to vote on matters put before shareholders until after the vesting period ends.
The recipient of a restricted stock grant may sometimes have to pay for the shares, in addition to fulfilling the vesting requirements. Other times, the restricted stock is simply granted to the recipient – again, subject to restrictions – without the need to purchase the shares.
What Is a Restricted Stock Award?
With RSAs, you’re awarded stock when you join the company and immediately become a shareholder with voting rights. The stock may have a purchase, or strike price, but likely it will be far below the stock’s current or potential value. Restrictions, potentially including a vesting schedule, still apply. So even though you’re awarded the stock on day one, you can’t sell until you’ve met the stated conditions.
Since you are technically buying the stock, you pay no taxes when the award is made unless you opt for what’s known as a Section 83(b) election, which you can make within 30 days of acquiring the stock. Under Section 83(b), the RSA is taxed as income, and there will be no taxes when the shares vest unless you sell them. When you do sell the shares, they are subject to capital gains tax, which is much lower than income tax if you hold the shares for longer than a year. If you sell before that, you’ll pay short-term capital gains tax, which is the same as your income tax rate.
An Example and a Caution
So imagine you take Section 83(b) on an award of 100 shares and pay $5 a share, which is much lower than the fair market value (FMV) of $20. You’ll pay income taxes on $15 per share, the difference between your strike price and the FMV. Now imagine those shares are worth $80 when they vest. Your profit is $75 per share, on which you’ll pay capital gains tax, not income tax, when you sell. In another scenario, imagine you’re given the stock and pay nothing for it. Under Section 83(b), you declare no income, and you’ll only pay capital gains when you sell.
There can be risks with a Section 83(b) election. If you lose your job before the RSA shares vest, they usually are repurchased by the company. If the company’s stock tanks, it will be worth little or nothing if you sell. In either case, you’ve paid income tax on the strike price, but you won’t see a profit. In effect you’ll have paid taxes on income you never received. Every RSA is different, as are the conditions in which they’re granted. You’ll want to analyze the details before making the call on Section 83(b).
What Is a Restricted Stock Unit?
RSU are promises of stock, but the recipient doesn’t own them or become a stockholder with voting rights until the shares are vested and all other conditions are met. Unlike RSA, RSU can be taken either as stock or cash once all restrictions lapse. RSUs also may call for the company or the employee to meet certain performance standards in addition to (or instead of) a time-based vesting schedule.
Since the RSU is just a promise of a stock award, it will not yield dividends until the stock is fully vested. As an example, you might accept 1,000 RSU when you accept a job offer. You do not own the stock and if you quit or are fired before any shares vest, you’ll forfeit the entire RSU. Otherwise, you will receive stock according to a vesting schedule, provided you meet any other conditions the company sets, which may be tied to your performance or company metrics.
RSU are not eligible for a Section 83(b) election. When these shares vest, you pay income taxes on their FMV, since unlike RSAs there is no sale price to deduct. Any gains the stock makes above the FMV are taxed at the capital gains rate. Once shares vest you will have voting rights and can receive dividends.
RSU grants are often used by companies that are a little further down the growth path. For instance, a company that has already gone public may use RSUs instead of RSAs or stock options. That’s because the share price may be too high for employees to afford to pay for options.
Restricted Stocks vs. Stock Options
The big difference between restricted stock and stock options concerns the options part. If your company offers you incentive stock options, you are under no obligation to exercise the option. If your company is in big trouble and its shares drop in value, you won’t take a financial hit unless you’ve already purchased shares through your option.
Restricted stock, if it’s part of your compensation package, is not an option. It’s yours unless you don’t meet established milestones and restrictions. Many executives will take restricted stock along with a lower salary since there is potential for significant gain if the company succeeds and increases in value.
Restricted stock, whether RSAs or RSUs, can hold a lot of potential value and are often coveted forms of compensation. Companies without many liquid assets or the means to pay high salaries can use them to attract talent by promising future gains and, in the case of RSA, immediate shareholder power. If you have been offered either RSA or RSU you might be in line for a nice payday, but be sure you’ve considered all the tax implications and restrictions involved before you count on the benefits. Knowing those rules and using them to your advantage can mean significant tax savings for people who receive restricted stock grants.
Tips for Managing Your Investments
- Tax planning needs to be central to your investment plan, especially if you own restricted stock or stock options. That’s where a financial advisor can be a big help. Finding the right financial advisor that fits your needs doesn’t have to be hard.
SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Wondering whether your existing savings and investments are enough for a secure retirement? Use our retirement calculator to project out your retirement income and see if you need to up your savings.
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