How Are RSUs Taxed in California?
Understanding the details of Restricted Stock Units (RSUs) is crucial for employees who receive them as part of their compensation package. It’s important to consider the various aspects of RSUs, including their structure, types, and the differences between them and other stock options.
This post clarifies what RSUs are, how they compare to other types of equity compensation, and their taxation nuances. Additionally, it offers insight on strategies to potentially reduce taxes on RSUs and guide individuals in seeking professional advice tailored to their unique financial situations.
Table of Contents
- What are RSUs?
- How are RSUs Taxed in California?
- Strategies for Lowering your RSU Taxes in California
- Get Help with RSU Taxation in California
What are RSUs?
Restricted Stock Units (RSUs) are a form of equity compensation awarded to employees. They represent a conditional promise to grant a specified number of company shares at a future date. Unlike traditional stock options, RSUs have intrinsic value at vesting, meaning they hold value even if the company’s stock price is low.
This form of compensation aligns the goals of company employees and shareholders since employees gain from the increase in the company’s stock value as time goes on. The vesting of RSUs is contingent on meeting certain criteria, typically involving continued employment for a set period.
Single-trigger RSUs vest based on one condition, usually the passage of time. Under this mechanism, employees earn the right to a portion of the RSUs after completing specific tenure milestones with the company. For instance, an employee might receive 25% of their RSUs after one year, with subsequent portions releasing to the employee annually.
This method is straightforward and easy to administer, encouraging employee retention by tying the vesting of RSUs to their continued employment. The moment these RSUs vest, they become taxable as ordinary income based on their fair market value. However, single-trigger RSUs are less common than their double-trigger counterparts.
Double-trigger RSUs involve two distinct conditions for vesting. The first trigger is similar to single-trigger RSUs, typically based on the employee’s tenure. The second trigger is contingent on a specific event, such as a merger, acquisition, or the company going public.
This dual conditionality provides an added layer of security for employees, ensuring their RSUs retain potential value in the event of significant corporate changes. Double-trigger RSUs help in attracting and retaining top talent, especially in startups and high-growth companies, where future liquidity events are anticipated.
ISO vs. RSU
Incentive Stock Options (ISOs), unlike a Restricted Stock Unit (RSUs), offer employees the right to purchase company stock at a price that is predetermined (i.e. the exercise price). This price is typically set at the market value of the stock at the time of the option grant.
ISOs are particularly appealing due to their favorable tax treatment; employees are not taxed at the time of the option grant or at vesting. Instead, taxes are incurred upon selling the stock, potentially qualifying for long-term capital gains tax rates if certain holding period requirements are met.
ISOs are more complex than RSUs in terms of administration and tax implications. They are subject to specific qualifying conditions, such as retaining the stock for a minimum of one-year post-exercise of the option and not less than two years subsequent to the grant date.
Failure to meet these conditions can convert the ISOs to non-qualified stock options (NSOs), which have different tax implications (see NSO vs. RSU section below). Moreover, ISOs can create alternative minimum tax (AMT) liabilities in the year of exercise, requiring careful tax planning.
Bottom Line: In contrast to RSUs, which provide actual shares upon vesting, ISOs offer the potential to purchase shares later. This gives, employees the choice to exercise their options based on the stock’s performance and their financial goals. ISOs can be more lucrative, but offer a riskier and more complex path compared to the straightforward and stable nature of RSUs.
NSO vs. RSU
Non-Qualified Stock Options (NSOs), diverge significantly from Restricted Stock Units (RSUs) in several key aspects. Like an Incentive Stock Option (ISO), an NSO grants employees the right to purchase company stock at a pre-set price, known as the exercise price (or strike price).
However, NSOs do not meet the specific IRS requirements that qualify ISOs for special tax treatment. Consequently, when employees exercise NSOs, they are subject to immediate taxation on the difference between the exercise price and stock’s market value (i.e., the bargain element). This tax is levied as ordinary income, contrasting with the potential capital gains treatment ISOs can offer.
The taxation of NSOs at the date of exercise, regardless of whether the shares are sold, marks a significant difference from RSUs, which are taxed as ordinary income only when they vest. NSOs are more flexible than ISOs regarding eligibility, as they can be offered to non-employees like consultants and board members, widening their applicability in various corporate structures.
Bottom Line: While RSUs provide an almost certain benefit if the employee meets the vesting criteria, NSOs carry inherent market risk. The value of NSOs is tied to the company’s stock price performance. This potentially offers higher rewards but poses the risk of the options being ‘underwater’ – when the exercise price exceeds the market value of the stock. This risk-reward balance is a pivotal consideration when comparing NSOs with the more stable, but potentially less lucrative RSUs.
How are RSUs Taxed in California?
The complexity of state taxes in California makes understanding RSU taxation particularly important. Individuals must be aware of the tax implications at both the time of vesting and when they decide to sell their shares.
The high tax rate in California, combined with federal taxes, can significantly reduce the net value of RSUs. Therefore, effective tax planning is important for anyone receiving RSUs in the state.
Understanding the Initial Tax Implications
When Restricted Stock Units (RSUs) vest in California, they are subject to income taxation. The vesting date marks the point at which the RSUs are considered taxable income. The value of the RSUs is calculated based on the market price of the company’s shares at vesting.
This value is subject to taxation at the federal and state levels. Employers are required to withhold taxes on the value of the RSUs at vesting, covering California state income tax, federal income tax, Social Security, California state disability insurance, and Medicare.
They are mandated to withhold a percentage of wages, ranging from 22% to 37%, in addition to adhering to California’s state tax requirement set at 10.23%. This withholding process helps manage the tax liability that arises upon vesting, ensuring the employees pay taxes appropriately.
California’s Progressive Tax Rate System
The tax rate in California is progressive, meaning that higher income levels are taxed at higher rates. For RSUs, this can significantly impact the amount of tax owed. As RSUs are added to an individual’s total income for the year, they can push taxpayers into higher tax brackets, increasing their overall tax burden.
The state tax rate for high-income earners can reach 13.3%, one of the highest in the nation. This rate is applied to the income from RSUs, in addition to other income sources, making it a substantial consideration for individuals receiving RSUs in California.
After RSU shares vest and are acquired, selling these shares can lead to additional tax implications. If the shares are sold for a higher price than their value on the vesting date, the profits are subject to capital gains tax. In California, this means both federal and state capital gains taxes apply.
The specific tax rate depends on the holding period of the shares. Long-term capital gains rates, which are lower, apply to shares held for more than a year post-vesting, while short-term rates apply to shares sold within a year of vesting. To maintain compliance with tax laws, individuals must report these transactions accurately on their tax return.
Strategies for Lowering your RSU Taxes in California
In California, effectively managing the tax implications of Restricted Stock Units (RSUs) is can be important to optimizing financial outcomes. Several strategies can be employed to mitigate the tax burden:
1. Immediate Sale of Vested Stock: Selling stock immediately upon vesting is a key strategy. As the cost basis of the stock is set on the vesting day, selling it at this time can avert capital gains tax, particularly if there has been no significant gain in the stock’s value.
2. Maximizing Contributions to Tax-Deferred Accounts: Increasing contributions to accounts like 401(k)s or Health Savings Accounts (HSAs) can reduce overall taxable income. This approach not only decreases current tax liabilities but also promotes tax-efficient growth of savings.
3. Charitable Contributions: Substantial donations to charitable organizations can offset taxable income, thereby reducing the tax burden. This strategy serves dual purposes: achieving tax efficiency and supporting philanthropic causes.
4. Bunched Deductions: Employing the strategy of deduction bunching—concentrating as many deductions as possible into a single tax year—can help in reducing the tax impact of RSUs. This method is especially effective in high-income years driven by RSU vesting, allowing for a significant increase in itemized deductions over the standard amount. Key areas for bunching include charitable donations and, when applicable, medical expenses.
These measures, tailored to individual circumstances and integrated into broader financial planning, can significantly ease the tax impact on RSUs in California. With professional financial guidance an individual can align these strategies with their personal financial goals.
Get Help with RSU Taxation in California
At Fischer Investment Strategies, we understand navigating the intricate web of tax laws and investment strategies can be overwhelming, especially when it comes to managing equity compensation like RSUs, ISOs, and NSOs. That’s where our expertise comes into play.
Our team of seasoned financial advisors is well-versed in the nuances of California tax laws and is adept at crafting personalized tax planning strategies. Without proper guidance, you might miss out on opportunities to optimize your investments and minimize tax liabilities. However, we’re prepared to consider all aspects of your financial portfolio, including RSUs and other stock options.
Whether you’re grappling with the decision of when to sell your vested RSUs, considering how to balance your stock options with other investments, or looking for ways to reduce your overall tax burden, our team is here to provide expert advice and support.
Don’t hesitate to get the most out of your equity compensation! You can call us directly at our Westlake office at (805) 418-7686, or our San Clemente office at (949) 433-7768. You can also schedule a complimentary consultation at a time that works best for you.
This commentary reflects the personal opinions, viewpoints and analyses of the Fischer Investment Strategies, LLC employees providing such comments, and should not be regarded as a description of advisory services provided by Fischer Investment Strategies, LLC or performance returns of any Fischer Investment Strategies, LLC client. The views reflected in the commentary are subject to change at any time without notice. Nothing in this commentary constitutes investment advice, performance data or any recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. Fischer Investment Strategies, LLC manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.
Ted Fischer is a Fee-Only Certified Financial Planner® & fiduciary, and the founder of Fischer Investment Strategies.
Drawing from more than 25 years of experience in the financial services industry, Ted's expertise includes retirement planning, investment analysis, tax planning, estate planning, and insurance.
Ted has an extensive academic background. He received his Certified Financial Planning (CFP®) designation from UCLA in 2011. He became a Qualified Plan Financial Consultant (QPFC®) and an Accredited Investment Fiduciary (AIF®). Ted has a Bachelor of Science in Marketing, with a minor in Finance, from San Diego State University.