Jan 18, 2023
Your restricted stock just vested: Should you sell now or wait?
Restricted stock is a key part of many stock-based compensation plans. Unfortunately, you can’t control when it vests (i.e., becomes yours to keep) because it follows a set process. When vesting happens in a down market, it certainly doesn’t feel good. And, depending on your particular industry, the share price of your company stock may decline much more than the overall market, which feels even worse and may have longer-term financial implications.
A common strategy we see is selling restricted stock when it vests and diversifying the proceeds. This may reduce risk, and also makes sense tax-wise because there’s no tax benefit to holding the stock longer. In general (i.e., aside from 83(b) elections), the total value of your restricted stock is taxed as ordinary income when it vests.
Here’s a quick example:
- 10,000 shares of restricted stock
- Price at vesting: $10
- Total value of the award at vesting: $100,000
- Full amount is taxed as ordinary income
That value also becomes your cost basis. In this example, your cost basis is $100,000. What happens when you sell the stock?
If you sell it for $100,000, you have $0 gain. There’s no additional tax on top of the ordinary tax you just paid. If you hold and sell it later at a profit, the difference in value is taxed as capital gains:
- You decide to sell it a year later when the value increases to $150,000
- You realize a $50,000 taxable long-term capital gain ($150,000 − $100,000 = $50,000)
- If the stock loses value, it’s considered a capital loss for tax purposes
When’s the best time to sell?
If the markets are down, does it still make sense to sell your vested restricted stock and diversify? Should you hold off and sell later when it will hopefully recover in price?
There are many things to consider, but one way to analyze it is by looking at break-even scenarios. In other words, how much better must your stock perform relative to a diversified portfolio in order to make up the capital gain tax you could pay later?
Here’s a simple analysis of a hypothetical scenario:
| Tax Rate (23.8% Fed, 4.95% IL): | 28.75% |
| Value at Vesting (Net of Ordinary Tax Due): | $100,000 |
| Diversify Now and Invest at 8% | Hold and Diversify Later | |||||||
|---|---|---|---|---|---|---|---|---|
| Year | Pre Tax Value | Year | Pre Tax Value | Cap Gain Tax | After Tax Value | Check | Annulized Pre Tax IRR Needed to B/E | |
| Now | $100,000 | Now | $100,000 | $100,000 | $0 | |||
| 1 | $108,000 | 1 | $111,228 | ($3,228) | $108,000 | $108,000 | 11.2% | |
| 2 | $116,640 | 2 | $123,354 | ($6,714) | $116,640 | $116,640 | 11.1% | |
| 3 | $125,971 | 3 | $136,451 | ($10,480) | $125,971 | $125,971 | 10.9% | |
| 4 | $136,049 | 4 | $150,595 | ($14,546) | $136,049 | $136,049 | 10.8% | |
| 5 | $146,933 | 5 | $165,871 | ($18,938) | $146,933 | $146,933 | 10.7% | |
Source: BDF LLC
The example on the left assumes you immediately sell your restricted stock. The proceeds (net of tax due at vesting) are re-invested in a diversified stock portfolio during a typical market environment earning 8% annually. On the right, it assumes you wait and sell your restricted stock later. The far-right column is the pre-tax rate of return you’d have to earn to end up in the same spot as on the left.
For this example, we assumed: 1) 23.8% for the Federal cap gain rate, which includes surtax, since many people with this type of compensation are high earners; and 2) a state tax of 4.95% (your state tax may be different).
This example shows that you’d have to earn about 2% to 3% more per year on your company stock to be equally well off. This is a big hurdle considering the odds of outperformance. According to the S&P Dow Jones indexes, historically most stocks have not delivered above-average returns. For example, only 22% of the stocks in the S&P 500 Index outperformed the index itself from 2000 to 2020.1
Now, we realize this analysis is overly simplistic. It doesn’t account for ending up with a larger unrealized gain on the left versus a higher cost basis on the right. Nor does it account for performance volatility, differences in rates of return, specific personal and state tax rates, or what happens in a loss scenario. Note that, for the example, on the right you need to account for the lost earning potential on the funds used to pay the capital gains tax. Also, don’t disregard the psychological effect of writing a big tax check as a result of waiting to diversify. Because of this, many investors take no action at all, prolonging the acceptance of more risk than may be wanted or necessary.
Despite all this, we still think the example emphasizes an important point. If you wait to diversify instead of selling your restricted stock once it vests, there’s a chance you’ll need to earn much more return and take on sector-based, single-stock and concentration risks.
ABOUT THE AUTHOR
Gary Pattengale, CPA, CFP
Gary is a Wealth Manager at BDF and member of the Firm’s Investment Committee. He specializes in executive and stock-based compensation plans, including stock options, restricted stock and deferred compensation. He combines his tax knowledge, executive compensation experience and capital markets expertise to help clients reduce their tax burdens and achieve each of their unique goals.
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