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). When it happens in a down market, it certainly doesn’t feel good. And depending on your industry, your stock may be down a lot more than the market, which feels even worse.
A common strategy is selling restricted stock when it vests and diversifying the proceeds. This reduces risk, and it makes sense taxwise because there is no tax benefit to holding the stock longer. In general (83(b) elections aside), the total value 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
- Taxed as ordinary income.
That value also becomes your cost basis. In this example, your basis is $100,000. What happens when you sell the stock?
If you sell it for $100,000, you have $0 gain. There is no additional tax on top of the ordinary tax you just paid. If you hold and sell it later, 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 it loses value, it’s a capital loss.
When is the best time to sell?
With the markets down, does it still make sense to sell your vested restricted stock now and diversify, or should you hold off and sell later when it recovers?
There are many things to consider here, but one way to analyze it is by looking at break-evens. In other words, how much better does your stock have to perform vs. the diversified portfolio to make up the capital gain tax you could pay later.
Here is a simple analysis:
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%/year. On the right, it assumes you wait and sell later. The far-right column is the pre-tax rate of return you would have to make to end up in the same spot as on the left.
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) 4.95% Illinois state tax.
This example shows that you would have to earn about 2-3% 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 Indices, most stocks do not deliver above-average returns. For example, only 22% of the stocks in the S&P 500 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 vs. a higher basis on the right. Nor does it account for volatility, differences in rates of return, personal and state tax rates, or what happens in a loss scenario. Take heed, you need to account for the lost earnings on the funds used to pay the capital gains tax on the right. Don’t disregard the psychological effect of writing a big tax check due to waiting to diversify. Because of this, many investors take no action at all, prolonging taking on more risk than may be wanted or necessary.
Despite all of this, we still think this emphasizes an important point. You will need to earn much more and take on sector, single-stock, and concentration risks by waiting to diversify.
1 Source: One Stat Shows How Hard it is to Pick Market-Beating Stocks; Yahoo! Finance, Sam Ro Contributor; December 19, 2021.
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.