Here’s the deal: You pay nothing; shares of your employer stock are reserved for you; a specific period of time passes; you pay personal income tax on the value of the shares; and now the shares are yours to keep or sell. Did you get that? You pay nothing and eventually receive employer stock. And, your only cost is the income tax paid. Hmmm….sounds pretty good!
Restricted stock awards have been gaining popularity across employers, but understanding how they work hasn’t come along quite as quickly. Lack of knowledge can cause you to miss an opportunity to maximize your benefits. You need a plan that considers your outlook on the stock, your personal tax situation, as well as your overall investment strategy. While restricted stock awards aren’t as straightforward as traditional compensation, they don’t have to be complicated.
Employers provide restricted stock awards to employees as a form of additional compensation. Employees then have ownership in the company and will benefit if the stock price increases. However, restricted stock isn’t yours right away. There is a window of time (called the “vesting period”) that you must meet before taking ownership. Shares may vest simultaneously or the vesting may be spread out over a period of time. For example, the vesting schedule could span five years with 20% of the grant vesting each year.
So what do you do with it once you have it? Oftentimes people don’t realize they have choices and therefore do nothing. While that may make sense in some situations, it’s not a plan.
Without proactive planning, the value of restricted stock is typically taxed as ordinary income on the vesting date. Selling on this date typically generates minimal to no additional tax liabilities. However, if you hold the shares, the cost basis is the value of the stock on the date of vesting, which is also the day the restriction was “lifted” and you took ownership of the shares. Depending on the holding period, short-term or long-term capital gains tax will apply.
Let’s assume you were granted 1000 shares and at the time of the grant, the stock was trading at $25 per share. However, on the vesting date the stock price is $40 per share. $40,000 will be taxed as ordinary income. The stock is now 100% yours. If you do nothing, you’ll continue to own the stock until you take action.
You can opt to sell the shares once they vest. If you sell at $40 per share, no capital gains taxes are owed. If you hold the shares initially and sell at $45 in the future, you now have a capital gain of $5 per share ($5,000 total). A holding period of more than one year between the vesting date and the sale of the stock results in a long-term capital gain. Sell within a year of the vesting date, and gains are taxed as short-term capital gains. Short-term capital gains are taxed at a higher rate than long-term capital gains, so it is important to know how long you’ve held the stock to understand the tax impact of the sale.
Just because you have to wait for the shares to vest in order to sell them, doesn’t mean you have to wait to make a plan.
Do you expect the stock price to increase before your shares vest? In the previous example, the stock increased from $25 to $40 between the grant date and vesting date. If you feel strongly about the ability of the stock to grow, you can elect to pay taxes when the restricted shares are granted, rather than waiting until the vesting date.
You’re making a bet on the stock’s future here, but if you are right, you will be reducing your tax bill. This is done by filing an 83(b) election with the IRS within 30 days of receiving the restricted shares. Sticking with our example, you would pay taxes on $25,000 in income rather than $40,000. In addition, you are also starting the holding period requirement for long-term capital gains.
But think this strategy through first! Just because you paid the taxes upfront, doesn’t mean the shares are yours. You still need to remain an employee until the shares are vested; otherwise, you forfeit the shares and the taxes you already paid. As second caution: the value of the restricted shares could also drop by the time of vesting, which means you paid more taxes based on the higher amount.
If you don’t have high expectations of the stock price, you’ll want to consider selling the stock once it vests. The tax impact will be minimal and you’ll be free to invest the proceeds as you wish.
Restricted stock awards can quickly grow to be a significant portion of your investment allocation. A general rule of thumb is that one company should not represent more than 10% of your investment portfolio. As restricted stock awards vest, pay attention to how much exposure you have to your employer. If business takes a turn for the worse, the value of your restricted stock will take a hit and possibly other aspects of your compensation as well!
What about employees who are considered “insiders” of the company? Restricted stock is a common component of executive compensation. Blackout periods and other restrictions often limit the timeframe for insiders to trade their shares of employee stock. Good news! They can be proactive too. Insiders can create a plan called a 10b5-1 to sell their stock when predetermined criteria are met. The price, amount, and sale dates must be set in advance in order to avoid insider trading allegations.
Restricted stock awards deserve just as much attention as other aspects of your portfolio. Don’t let them become an afterthought. Talk with your financial advisor about putting together a restricted stock strategy that coordinates with your financial plan.
Sarah Mahaffa is a Senior Wealth Advisor with Bedel Financial Consulting Inc., a wealth management firm located in Indianapolis. For more information, visit their website at www.bedelfinancial.com or email Sarah at email@example.com.