Since restricted stock is subject to a vesting schedule, you do not own the stock shares until the vesting requirements are met. When the restrictions lapse, your shares are taxed at ordinary income rates, which are almost always higher than capital gains rates.
The IRS requires the employee to provide the required withholding of ordinary income tax at the time the shares vest. Generally, when employees are notified they have shares that will vest soon, they are given the options for paying the tax due. You should be able pay the income tax to your company by check, wire, payroll deduction, or by withholding shares.
For example, you have 1,000 shares that will vest at the end of the month. Your company notifies you that the estimated closing price of the stock is $35. On that day, $35,000 will be included in your wages, subject to federal and state ordinary income tax and employment taxes. Based on this, your estimated taxes due on the 1,000 shares should be $11,673 — a flat federal withholding rate of 25 percent on supplemental payments, 6 percent for Georgia state taxes, and Medicare tax of 2.35 percent, assuming you have maxed your Social Security earnings though your wages and are required to pay an additional Medicare tax. You have the option to have 333 shares — calculated by dividing the estimated tax liability by the estimated closing price — withheld to cover your tax liability. In this case, you actually receive 667 shares after the taxes are withheld.
Alternately, when you were granted the restricted stock, you may have been presented paperwork on a Section 83(b) election. This filing lets the IRS know you want to pay the taxes on your restricted stock at the time of the grant rather than after it is vested. You then pay ordinary income tax based on the value of the stock on the grant date.
Let’s say you are granted 15,000 shares that vest in five years. If the current value of the stock is $15, your shares are worth $225,000. By filing an 83(b) election, you report the income now in exchange for long-term capital gain treatment upon the sale in the future on any appreciation over $15 per share (assuming you hold the shares at least one year). If the stock price increases, you should pay less in taxes on your restricted stock. However, if you were to leave the company, forfeiting the unvested restricted stock shares, the taxes paid to the IRS based upon the 83(b) filing is nonrefundable. You are also counting on the company stock to appreciate in the future.
Most often, a Section 83(b) election is recommended when you are granted shares of a growing start-up company. However, for Fortune 500 companies, the stock price may not grow as exponentially as a start-up might. This is a situation where discussing your options with a tax adviser or C.P.A. would be beneficial.
Next week I’ll take a closer look at how restricted stock creates some unique financial planning needs.
William G. Lako, Jr., CFP®, is an Executive in Residence at Kennesaw State University’s Coles College of Business and a principal at Henssler Financial. Mr. Lako is a CERTIFIED FINANCIAL PLANNER™ professional.