How Does Employee RSU Vesting Work?

Restricted Stock Units (RSUs) are a form of equity compensation provided by companies to employees. Unlike stock options, RSUs represent a promise to deliver company shares or their cash equivalent once certain conditions are met. Understanding how these units transition from a promise to actual ownership is important for employees. This process, known as vesting, dictates when an employee gains full control over the awarded shares.

Understanding RSU Vesting

Vesting is the process by which an employee gains full ownership of their awarded Restricted Stock Units. Before vesting, RSUs are a contingent promise, and the employee does not possess shareholder rights like voting or dividend eligibility. The primary purpose of vesting from a company’s perspective is to incentivize long-term employee retention and align employee interests with shareholder value. By tying the ownership of shares to continued employment or performance, companies encourage employees to remain with the organization and contribute to its success, ensuring a stable workforce.

For employees, RSUs are deferred compensation, offering potential growth tied to the company’s stock price. An RSU award’s value can appreciate significantly from grant to vesting, providing a valuable financial benefit. Once vested, these shares become personal assets, free from restrictions, linking personal wealth directly to company performance.

Common Vesting Schedules

Companies use various schedules to determine when RSUs vest and become fully owned. Cliff vesting is a common arrangement where all granted RSUs vest entirely on a specific date after a set period, often one year from the grant date. For instance, an employee granted 1,000 RSUs with a one-year cliff schedule receives all shares on the first anniversary, provided they are still employed. This ensures a minimum service period before shares are released.

Graded vesting allows a portion of RSUs to vest incrementally over time. A typical graded schedule might involve 25% vesting each year over four years, often with a one-year cliff before the first tranche. For example, 1,000 RSUs on a four-year graded schedule with a one-year cliff would mean 250 shares after one year, then 250 each subsequent year, until all are vested at the fourth year’s end. This gradual release provides ongoing incentives.

Some RSU awards incorporate performance-based vesting criteria, requiring specific individual or company goals in addition to a time-based schedule. Metrics can include revenue targets, product development milestones, or maintaining a stock price. If performance conditions are not met, RSUs may not vest, even if time requirements are satisfied, directly linking compensation to organizational success.

What Happens at Vesting

When RSUs vest, they transition from a contingent promise to actual shares owned by the employee, and restrictions are lifted. Companies typically transfer vested shares into an employee’s designated brokerage account. Many automatically set up accounts with a preferred broker, simplifying share delivery.

Vesting has immediate tax implications. Companies generally withhold a portion of vested shares or their cash equivalent to cover the employee’s tax obligations. This withholding is similar to taxes withheld from a paycheck, covering federal, state, local, Social Security, and Medicare taxes. The number of shares withheld depends on the fair market value at vesting and applicable tax rates.

After tax withholding, remaining shares are deposited into the employee’s brokerage account. The employee then has full ownership and control, able to sell immediately, hold for appreciation, or integrate into their investment portfolio. This transfer marks the completion of vesting and RSU award realization.

Tax Implications of Vesting

Upon vesting, the shares’ fair market value (FMV) on that date is taxable income to the employee. This amount is treated as ordinary income, like salary, and is subject to federal, Social Security, and Medicare taxes. For example, if 100 RSUs vest at $50 per share, the employee recognizes $5,000 of ordinary income, typically reported on their Form W-2 for that year.

To cover tax obligations, companies commonly use a “sell-to-cover” method, selling a portion of vested shares to remit taxes. Employees may also pay taxes with cash from other sources, if offered. The company withholds the correct amount and remits it to tax agencies.

The withheld amount aims to cover statutory obligations, including federal income tax at a supplemental wage rate (often 22% for amounts up to $1 million). However, actual tax liability can exceed the withheld amount, especially for higher earners, potentially leading to additional tax due. Employees should review their tax situation to avoid underpayment penalties.

Post-Vesting Considerations

Once RSUs vest and initial tax obligations are settled, employees gain full control, with two primary options: holding or selling. Holding shares means retaining company ownership, benefiting from future appreciation and dividends as a registered shareholder. However, holding carries the risk of depreciation if the stock price declines.

Alternatively, an employee may sell vested shares. Any gain or loss from the sale is subject to capital gains tax. The cost basis is the fair market value on the vesting date, already taxed as ordinary income. Selling for more than vesting FMV results in a capital gain; selling for less results in a capital loss.

Capital gains tax rates depend on the holding period after vesting. Shares held for one year or less are subject to short-term rates (equivalent to ordinary income tax rates). Shares held for more than one year are subject to long-term rates (typically lower). Understanding this distinction is important for tax planning.

Forfeiture and Leaving Employment

RSU awards depend on continued employment. Generally, if an employee leaves the company before their RSUs vest, all unvested units are forfeited. This means the employee loses any claim to those shares, regardless of the reason for separation, including voluntary resignation, termination, or retirement, unless specific plan provisions state otherwise.

Some company plans include clauses altering this forfeiture rule. For example, a “good leaver” provision might allow accelerated vesting or retention of unvested RSUs if an employee leaves due to disability or retirement after long tenure. Corporate events like a change of control can also trigger accelerated vesting. These exceptions are typically outlined in the original RSU grant agreement.

Employees should review their RSU grant agreements and company equity plan documents to understand forfeiture terms. These documents detail conditions for losing unvested RSUs and any exceptions. Understanding these provisions helps employees plan for their financial future, especially when considering career transitions and their impact on equity compensation.