How Do Restricted Stock Units (RSUs) Work?

Restricted Stock Units (RSUs) represent a form of equity compensation offered by employers. They function as a promise from a company to grant its employees shares of company stock once specific conditions are fulfilled. This compensation method aligns employee interests with the company’s performance, providing an incentive for sustained contributions.

Defining Restricted Stock Units

Restricted Stock Units (RSUs) are a type of equity compensation where an employer commits to deliver company shares to an employee at a future date, provided certain restrictions are met. Unlike traditional stock options, which grant the right to purchase shares at a set price, RSUs represent a direct award of stock without any upfront cost to the employee. RSUs have inherent value upon vesting, as they represent actual shares of the company, unlike options that may become worthless if the market price falls below the exercise price.

The “restriction” component of RSUs typically involves conditions such as continued employment for a specified period or the achievement of performance-based milestones. Companies utilize RSUs for employee retention, as the delayed grant encourages employees to stay and realize the full value. This fosters a sense of ownership and aligns efforts with the company’s long-term success.

The Vesting Process

Vesting is the process through which the restrictions on RSUs are lifted, and the employee gains full ownership of the shares. This process is governed by a predetermined schedule established by the employer. Vesting schedules vary, but they commonly include “time-based” and “performance-based” conditions. Time-based vesting typically requires continued employment for a specific duration.

One common time-based approach is “cliff vesting,” where no shares vest until a set period, often one year, has passed; after this period, a significant portion or all of the RSUs vest at once. Another prevalent method is “graded vesting,” where a percentage of the RSUs vests gradually over time, such as 25% each year over a four-year period. Performance-based vesting links the vesting of RSUs to the achievement of specific company goals, such as revenue targets or project completion. If an employee leaves the company before their RSUs vest, they generally forfeit the unvested units.

Taxation of Restricted Stock Units

Taxation of Restricted Stock Units primarily occurs at the time of vesting. When RSUs vest, the fair market value of the shares on that date is treated as ordinary income to the employee. This value is subject to federal income tax, state income tax (if applicable), Social Security taxes, and Medicare taxes. Vested shares are taxed at the employee’s marginal income tax rate.

Employers typically manage immediate tax obligations through a process called “sell-to-cover” or “net share settlement.” The company automatically sells a portion of vested shares to cover required tax withholdings. The remaining shares are then deposited into the employee’s brokerage account.

The cost basis for vested RSU shares is established at their fair market value on the vesting date. This cost basis is used for determining capital gains or losses when the shares are eventually sold. If the shares are sold immediately upon vesting, there is typically no additional capital gain or loss, as the sale price matches the cost basis. However, if the shares are held after vesting and their value fluctuates, any difference between the sale price and the vesting date’s fair market value will be subject to capital gains tax. If shares are held for more than one year after vesting, any gain is taxed at potentially lower long-term capital gains rates; otherwise, short-term capital gains rates, which are equivalent to ordinary income tax rates, apply.

Actions After Vesting

Once RSUs have vested and initial tax obligations are settled, employees gain full control over the shares. At this point, individuals have two primary choices: holding the shares or selling them. The decision to hold or sell depends on various personal financial factors, including diversification goals, risk tolerance, and individual financial objectives.

Holding the vested shares means the employee retains ownership of the company stock, which can provide eligibility for dividends if the company issues them. This strategy allows for potential appreciation in the stock’s value over time, aligning the employee’s financial success with the company’s continued growth. However, holding a significant portion of one’s wealth in a single company’s stock can create concentration risk, making diversification an important consideration.

Alternatively, an employee can choose to sell the vested shares, either immediately or at a later date. Selling immediately after vesting often simplifies tax reporting, as the sale price typically matches the cost basis, resulting in no additional capital gains or losses. If shares are held for a period after vesting and then sold, any gain or loss from the vesting date onward is subject to capital gains tax. It is generally advisable to consider selling enough shares to diversify one’s portfolio, rather than maintaining an overly concentrated position in employer stock.