Since we started our financial independence journey in 2011, we have been following the same process every two weeks. We earn income, spend less than we earn, invest the money we save in dividend paying stocks and index ETFs, rinse and repeat, and let compounding do its slow, boring, and wonderful thing. For the most part, this slow, boring process works for us because it’s predictable, and we can stick to the same routine.
What happens when something lands that doesn’t fit nearly into this biweekly routine?
If you work at a publicly traded company, you might know what I am referring to: Restricted Stock Units, also known as RSUs. What happens when these RSUs vest and money in the tens-of-thousands-of-dollars range lands in your bank account?
Don’t get me wrong, having a large batch of company stock (or cash when you sell the shares) showing up in your account is a great thing. But at the same time it is a problem (albeit a nice problem).
What do you actually do with the RSU money? This is perhaps something most FIRE bloggers don’t talk about. More specifically, what do you do when you’re getting close to living off dividends and your RRSPs and TFSAs are already maxed out?
I thought it’d be worthwhile to go over the basics of RSUs and what we are considering when some of my RSUs vest later this year.
Please note, this is our tentative plan at the time of writing. Since personal finance is personal, someone else may make different decisions than us.
RSUs vs Employee Stock Options
First, there are two types of stock compensation: RSUs and employee stock options. Both are for rewarding and incentivizing employees to stick around and help the company grow.
With employee stock options, the company grants you a certain number of shares that you can purchase at a set price on specific dates over a set period. For this type of reward, it really only makes sense to exercise when the share price is higher than your option price. For example, if your options are set at $20 for 2,000 shares and the stock price is $30, you can exercise the option by buying the shares at $40,000, sell your shares at $30, and get a profit of $20,000. You can also exercise the options to get the eligible shares and sell them later.
When you sell the options immediately, the brokerage firm can typically handle the purchase and the sale in a single simultaneous transaction. This means you don’t need personal cash up front. However, if you don’t sell immediately, you need to pay the total strike price cost to the broker.
Employee stock options carry some risk. If the share price is below your exercise price, it typically doesn’t make sense to exercise your options and you end up with nothing. This is what happened to many tech employees during the dot-com bubble.
With RSUs, the company grants qualified employees a certain number of RSU shares at a predetermined price (i.e. grant price). RSUs are typically divided into three equal portions, with each portion vesting one year apart from the grant date over three years (sometimes the vesting period could be longer). Then, on vesting day, the RSUs convert to real shares. You can decide whether you sell immediately or keep the shares and sell later.
The nice thing with RSUs is that you’d get some money regardless of how the company stock is performing. If the stock price is lower than the RSU grant price, it simply means you get the shares at a lower cost basis (the worst case scenario is that your cost basis is lower than the grant price).
Whether you get compensated in employee stock options or RSUs depends on the company. Personally, I have only received RSUs.
How RSUs are taxed in Canada
For RSUs, there are two important dates. The grant date, which is when the company promises you the shares. The vesting date, which is when the RSUs convert to real shares and become yours to keep or sell.
In Canada, RSUs are taxed as regular employment income the moment they vest, not when you sell them. When RSUs vest, the full market value of the shares on the vesting date gets added to your T4 income for the year. There’s no deferral and no 50% deduction.
Because it’s a big tax bill, most employers use what’s called a “sell-to-cover” mechanism. On the vesting date, employers automatically sell a portion of your shares for the CRA withholding tax and you get to keep the rest. Typically, 51% of the share value goes to taxes and you get the remaining 49%.
Once the shares vest, your adjusted cost base (ACB) is set at the market value on the day of vesting. If you hold the shares and the share price goes up, you’d trigger a capital gain and half of the capital gain is taxed. If you sell immediately upon vesting, typically there’s no capital gain or loss, unless the share price jumps or drops significantly on vesting day.
Although employers usually allocate 51% of the shares to cover taxes, it may not be enough. If you get pushed into a higher tax bracket, you may end up with a surprise bill when you file your taxes.
RSU decisions – sell at vesting or hold?
The biggest decision whenever RSUs vest? Do you sell or do you hold?
For me, I have been leaning heavily on selling at vesting.
Why?
One, because my company stock is extremely volatile. Over the past five years, the stock has had a five-year monthly beta of around 2.5. I’ve seen the stock go up by 10% one day only to drop by 15% the next day. It’s not for the faint of heart! Therefore, it makes sense for me to lock in and realize the money whenever I can.
Second, since RSUs are spread out over three years and more RSUs are granted each year, it means more shares will vest at later dates. If the stock price continues to go up, I’d be able to take advantage of the gain with RSUs that vest later. Holding on to already vested shares in the hope of additional capital gains is like gambling.
Third, the company already provides our family a big part of our financial security in the form of my biweekly paycheques and our extended health benefits. So holding onto a large position in the company stock is like putting all of our eggs in one basket. What if the company has a couple of bad quarters or a bad year, resulting in me losing my job and the share price tanks? That’d be a triple whammy! At this point in our FIRE journey, as we prepare for our eventual early retirement, de-risking is a major investing theme. So it doesn’t make sense to deliberately build up a large concentrated position in one stock.
Finally, I am on the company trading blackout list, which means that about two months before the quarterly earnings report, I cannot trade shares. The trading window usually opens a couple of days after earnings and remains open for about a month. In other words, every year, I only have a four-month window that I’m allowed to sell shares. This is very restrictive, so it makes sense to sell shares whenever I can.
On the flip side, someone might decide to hold the vested shares due a strong belief that the shares are undervalued. This makes sense if the stock is indeed undervalued. Another reason for not selling would be if this triggers a meaningful capital gain or puts you into the next income tax bracket. In this case, holding and deferring the capital gain may make sense.
Where does the money go?
Once we sell the vested shares and end up with a pile of cash, what do we do with that money?
If we don’t already have our registered accounts maxed out, that’s where the money would immediately go. Maxing out RRSP contributions makes a lot of sense after getting a pile of cash because RRSP contributions lower your net income.
More often than not, our TFSAs and RRSPs are already maxed out when I sell the vested RSUs, so this is typically what we do:
Build up the cash wedge. Regular readers know that we have been building up a cash wedge as we get closer to living off dividends. When we receive RSU money, we have been adding money to the LTSS. Our long term goal is to have between a year to two years’ worth of living expenses in cash. This way we won’t need to worry about which way the market is going or the overall safety of our dividend income.
Planned big purchases. If we have planned big purchases, we usually set some RSU money aside. For example, since we plan to replace our iMac later this year, we’d set aside a few thousand dollars, so we have the money to purchase a new computer without dipping into our cash wedge.
Future TFSA and RRSP contributions. If we receive the RSU money closer to the end of the year, I may set aside some money for next year’s TFSA and RRSP contributions.
Future RESP contributions. We have maxed out Kid 1.0’s RESP, but we still have room for Kid 2.0’s RESP (to get the government grant). So we will allocate some RSU money toward future RESP contributions.
Invest in a taxable account. Since we have maxed out both TFSAs and RRSPs, the only remaining investment vehicle is really my taxable account (I can’t transfer the money to Mrs. T’s taxable account as that goes against the attribution rules). The nice thing with the taxable account is that there’s no contribution limit.
A few things to watch out for
Getting shares vested means getting a lump of income for that year. When we sell the shares and if there are capital gains, that’s additional income on top. Therefore, if RSUs are granted close to the end of the year, it may make sense to sell in the new year and defer the capital gain.
It’s vital to keep good records of the ACB. When you have shares vesting across multiple years, your cost base gets averaged across all the shares. It’s easy to lose track if you sell shares from different grants at the same time. If your company stock is listed in the US, you also need to keep track of the exchange rates on the day of vesting and the day you sell.
Despite employers utilizing sell-to-cover, it doesn’t always withhold enough. It may make sense to set aside extra cash for the tax bill.
Summary – RSU vestige meets FIRE
It’s very nice to get compensated via equity. When the company stock is doing well, you can reap significant gains. What to do with the equity compensation money, however, typically requires a different decision process than the regular paycheques. The decision process can be quite different when you are close to early retirement and your registered accounts are already maxed out for the year.
As always, we try to keep things somewhat fluid to give us flexibility. What we do with the RSU money really depends on when the RSUs vest, what the company stock does in that time period, and whether or not it makes sense to defer the selling decision to later for tax reasons. For the most part, we sell when RSUs vest but sometimes we do figure it out as we go as that’s the fun part of planning for early retirement.
If you have dealt with RSUs or another windfall on your own FIRE journey, I’d love to hear how you handled it.
