Restricted Stock is a popular way to incentivize employees. There are two stock bonus structures – restricted stock units (RSU) and restricted stock awards (RSA). Both can be a fantastic incentive but they have important differences that may affect your financial plan. Below we are going to discuss RSU vs RSA and the differences that you need to know about.
How do restricted stocks work?
The easiest way to understand how restricted stock works is that they are restricted as you still have to earn them after they are issued. A common restriction is a vesting schedule which means that the shares are earned over time. This incentivizes employees to stay with the company longer. Restricted stock is usually offered by young companies who cannot afford to pay their employees a high salary yet. There are two types of restricted stock – restricted stock units and restricted stock awards.
What are restricted stock awards (RSA)?
A restricted stock award is a type of restricted stock. You are ‘awarded’ stock when you join the company and immediately become a shareholder with voting rights. If you have an RSA, then you own the right to purchase shares of your company’s stock at a set price, or you own the right to claim a set number of shares for free. RSAs are given on the grant date (usually when you start a job) but restrictions, such as a vesting schedule, still apply.
Pros of RSAs
1. Grant date: You are generally granted the stock as soon as you join the company.
2. Shareholder: As soon as you are granted the stock you become a shareholder and have voting rights.
3. 83(b) election: You can make an 83(b) election which can greatly reduce your taxes.
Cons of RSAs
1. Upfront payment: You have to provide payment to purchase the RSA shares at grant date (either at fair market value, at a discount, or at no cost).
What are restricted stock units (RSU)?
An RSU is much simpler than a RSA. A restricted stock unit (RSU) is compensation given to an employee as company stock without needing to pay for them. The RSU stocks are received later when the vesting is complete. They are offered to employees through a vesting plan and distribution schedule.
The employee doesn’t own them or become a stockholder with voting rights until all of the requirements in the plan have been met. These requirements could include staying with the company for a particular amount of time or achieving performance milestones. When an RSU is granted, it gives employees interest in the company’s stock but there is no tangible value until the vesting is complete.
Pros of RSUs
- Long term incentive: Employees are incentivized to stay with the company longer and put more effort into growing the company so that they get the highest possible value for the stock.
- Low-impact: RSUs require minimal managerial work.
Cons of RSUs
- No dividends: RSUs do not provide dividends while they have not yet vested.
- Shareholder voting rights: There are no shareholder voting rights until the shares are fully vested.
- No tangible value until the shares vest and restrictions lapse.
What is the difference between RSAs and RSUs?
RSAs and RSUs are both restricted stocks but they have many differences. An RSA is a grant which gives the employee the right to buy shares at fair market value, at no cost, or at a discount. An RSU is a grant valued in terms of company stock, but you do not actually get the shares until the restrictions lapse or vest. As soon as the conditions are met, then the employee will receive the shares in the form of stock or cash.
Two types of taxes are relevant for restricted stock – ordinary income tax and capital gains tax. Taxation of RSAs and RSUs can be complicated. RSAs are bought on the grant date and any taxable gain between the grant date and vesting is subject to ordinary income tax. Once the shares vest, any subsequent gain between vesting and sale is subject to capital gains tax.
RSUs are not purchased so they are only taxed (as ordinary income) once the shares are granted after it vests.
RSAs have time-based vesting conditions and RSUs have a lot of vesting conditions until the employee becomes the owner of the shares. The person who gets RSA shares owns them, however the vesting for RSAs affects whether the company can repurchase the shares if the person leaves the company. Many companies have a vesting schedule to avoid a case where an employee joins the company, gets their RSA and then immediately leaves the company.
RSU shares aren’t issued to the employee until they vest. The company grants the RSU with a vesting schedule and promises to deliver those shares later as per the vesting schedule.
RSAs are eligible for the 83(b) elections which can see a future tax bill greatly reduced. RSUs are not eligible for the 83(b) elections. The 83(b) election is when an employee can choose to pay all the ordinary income tax upfront for the RSA. The deadline to file an 83(b) election is 30 days from the grant date so keep that in mind.
The settlement for RSUs can be in stock or in cash. The settlement for RSAs must be in stock.
Entitlement to dividends
For RSUs, there is generally no entitlement to dividends or voting rights. For RSAs, you are entitled to dividends and voting rights.
If you leave a company before the shares of your RSU or RSA have vested, then things can be a little complicated. Unvested RSA shares are subject to repurchase upon termination and unvested RSU shares are forfeited back to the company upon termination.
How does a 83(b) tax election for RSAs work?
A 83(b) tax election lets people who have RSAs pay ordinary income tax on the RSA before it vests. The ordinary income is the difference between the fair market value of the stock at grant and the amount the employee paid (if any) for the shares. Any gain or loss after the shares vest is long-term capital gain or loss. After the RSA has vested and sold, the capital gain or loss will be taxed at the capital gains tax rate. We will illustrate this with two examples below.
Regular tax method:
Chloe has an RSA and accepts an award of 100 shares of stock for $0/share when the stock is trading at $40/share. 4 years later the stock vests and is trading at $60/share. She decides to hold the stock for another year and then sells all of her shares when the stock price is $70/share. At vesting, Chloe owes ordinary income tax on the difference between the stock price at the time of vesting ($60) and what she paid for the shares ($0), times the number of shares awarded. This means that $6000 would be included in her regular taxable income. When she sells the stock after meeting the long term capital gain requirements she will have a capital gain of ($70-$60) x 100 = $1,000.
Within 30 days of accepting the grant, Chloe makes an irrevocable 83(b) election with the IRS and notifies her employer. The shares will vest in 4 years but first, she must pay ordinary income tax on the difference between the stock price at grant ($40 x 100 = $4,000) and what she paid for the shares ($0). This is $4,000. Four years later, Chloe’s shares vest (no taxes are due) and she decides to hold onto them for another year. When she sells the stock one year later, she will have a capital gain of ($70 – $40) x 100 = $3,000. This will be taxed at the more favorable long-term capital gains rate.
What should I do with my RSU or RSA?
The first thing you will want to figure out is if you were offered or have RSUs or RSAs. Then you need to look at the vesting schedule and see if there are any other requirements beside vesting. You could then set a schedule so you know when your stocks start vesting.
For an RSA, you need to decide whether to accept the grant or not. And if you accept, whether or not to take the special tax 83(b) election. For an RSU, once the shares start vesting then you need to decide if you want to keep them or sell them. Both of these decisions will largely depend on how you think the company is doing. A certified financial planner can also help you make a decision about what to do with your RSU or RSA.
Which type of restricted stock is right for you?
While there are many similarities between RSAs and RSUs, there are also many differences that we highlighted. Ultimately the decision comes down to what you think is best for your financial situation. At District Capital Management, we work with a variety of clients who have RSUs or RSAs as part of their compensation package. If you are interested in a comprehensive financial plan with RSU or RSA recommendations, schedule a free discovery call with one of our financial advisors today.
Alvin Carlos, CFP®, CFA is an investment advisor and fee-only financial planner, in Washington, D.C that works with clients across the country. He has a Master’s degree in International Relations from SAIS-Johns Hopkins. Alvin is a partner of District Capital, a financial planning firm designed to help professionals in their 30s and 40s achieve their financial goals through smart investing, reducing taxes, retirement planning, and maximizing their money. Schedule a free discovery call to learn how we can help elevate your finances.