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  • Writer's pictureNicholas Pihl

A Good, Easy Decision for RSUs

One of the biggest mistakes I see among people who have RSUs (Restricted Stock Units) as part of their compensation packages is that they keep holding the stock after it vests.

RSUs are treated as taxable income when they vest. From a tax standpoint, it doesn't make a difference whether your employer paid you with RSUs or wrote you a check for an equivalent dollar value. Suppose you have 100 shares that vest, and those shares are worth $100 per share, or $10,000 total. Those $10,000 of vested RSUs is the same, for tax purposes, as $10,000 extra in your paycheck. The outcome is the exact same. You have essentially received a check for $10,000 and used those funds to buy stock in the company. Just without the extra steps.

This is important because you still owe tax on the RSUs, even if you don't have the liquid funds to pay the taxes with. Oftentimes, people will opt to sell some of their newly vested RSUs to pay the tax bill. If you don't want to sell your RSUs, you'll have to come up with money from someplace else, like your paycheck.

Now, what happens when you buy a stock and then sell it for no gain? Do you owe any taxes? No, you do not. This is what is happening with your RSUs if you decide to sell them as they vest. You already incurred the tax liability when they vested, you don't owe any extra taxes if you sell them immediately.

This is beneficial for two reasons. First, it helps you avoid unnecessary strain on your cash flow. Second, you are free to diversify that money in any way you wish. This is important because people with stock-based compensation often end up with portfolios that are highly concentrated in a single stock. Worse still, they end up with portfolios concentrated in the company they work for. It is unwise to have your net worth tied up in the same company you work for. If things go well, there's no problem, of course. But what if things go poorly? Not only does your net worth take a hit, you might also get laid off, see reductions in your compensation package, or even see the entire company go bankrupt.

This is more likely than you might think. Consider the profile of returns for venture-capital backed companies, and even those in the technology space. In the VC world, it's expected that roughly 1 company in 10 will provide virtually all of your gains. 9 out of 10 are expected to fail entirely. As a start-up employee, there is roughly a 90% chance that the company you work for will fail. Do you want your net worth to be concentrated in that same company, such that you are both unemployed and broke at the same time? No way, Jose.

By the way, among publicly traded companies, the failure rate is only slightly better, with roughly 74% of companies suffering a catastrophic loss from which they do not recover.

This is why it's such an easy decision to diversify. There aren't any tax-advantages to staying concentrated in your employer's stock, and the downside risk to doing so is tremendous. Unless, you have been careful with your benefit elections, you may have implicitly opted to YOLO much of your net worth into a single stock. While there are nutcases who do this (though usually not more than once), I think most people end up in this boat simply because they aren't aware of the consequences of their compensation elections.

Now, if you don't keep the RSUs, what should you do with the money you get from selling them? A great option is to max out your 401k contributions. This helps you diversify much more broadly and maximizes your chances of a great outcome down the road. Additionally, if you're making those contributions on a pre-tax basis, you receive a nice tax deduction for any funds contributed. Maxing out an HSA, a health savings account, is another good option if you and your family are healthy and have minimal medical expenses.

Beyond that, you can set up a taxable investment brokerage account to invest those proceeds. Tax-wise, this isn't any worse from holding the RSUs, but it's a lot better for diversification. Even a simple index fund (preferably an ETF rather than a mutual fund), will do you a lot of good. These funds tend to be tax-efficient, and can grow for years without incurring capital gains. You'll owe taxes on dividends received, but these will be pretty minimal for the first several years as the S&P 500 has relatively low dividend yield.

The most financially savvy people I know all have a taxable brokerage account. This account helps provide them with the best opportunities for a low-tax or no-tax retirement, as well as access to emergency liquidity along the way.

[disclaimer: there is a razor-thin exception to what I've discussed about automatically liquidating your RSUs. It has to do with non-publicly traded companies that later go public, where stock awards are converted to RSUs. The situation typically involves an 83(b) election as well, but I've tried to keep my discussion broad and simple for now].

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