What Are Restricted Stock Units and How Do They Work?

Restricted Stock Units (RSUs) are a common component of employee compensation. They represent a promise from an employer to grant company stock shares to an employee on a future date, provided certain conditions are met. Unlike traditional stock options, RSUs do not require the employee to purchase the shares. This equity compensation aims to incentivize employees to remain with the company.

Understanding Restricted Stock Units

Restricted Stock Units are a form of equity compensation where an employer grants an employee company shares that are “restricted,” meaning they are not immediately owned. These shares are subject to a vesting schedule, which outlines conditions that must be fulfilled before the employee gains full ownership. Conditions often relate to continued employment for a specific period or the achievement of performance milestones. Until vesting requirements are satisfied, RSUs cannot be sold or transferred.

Vesting is the process by which an employee earns full rights to the RSU shares. RSUs serve as a retention tool, as employees typically forfeit unvested units if they leave the company before vesting conditions are met. The value of vested shares directly correlates with the company’s stock price. Once vested, RSUs are treated similarly to shares purchased on the open market, providing the employee with ownership.

The RSU Lifecycle

The RSU lifecycle begins with a grant date, the day the company awards the RSUs to an employee. At this stage, the employee does not yet own the shares, but receives a promise of future ownership contingent upon meeting specific criteria. The RSU agreement details a vesting schedule, specifying when and how these units convert into actual shares. Vesting schedules vary, but common structures include time-based, performance-based, or a combination.

Time-based vesting often requires an employee to remain with the company for a predetermined period, such as four years, with a portion of the RSUs vesting annually or quarterly. Some plans may include “cliff” vesting, where no shares vest until a specific period, typically one year, has passed, after which a substantial portion vests, followed by a graded schedule. Performance-based vesting, more common for executives, ties the release of shares to the achievement of specific company or individual performance goals. Once vesting conditions are met, restrictions are lifted, and shares are delivered to the employee’s brokerage account.

Tax Implications of RSUs

Taxation of Restricted Stock Units primarily occurs at vesting, when shares are delivered to the employee. At this point, the fair market value (FMV) of vested shares is considered ordinary income. This income is subject to federal, state, and payroll taxes, similar to a cash bonus or regular wages. Employers are generally required to withhold taxes on this income, often at a federal supplemental wage withholding rate of 22% for income up to $1 million, and 37% for amounts exceeding $1 million.

To cover these tax obligations, companies commonly employ a “sell-to-cover” strategy, where a portion of vested shares is automatically sold to satisfy required tax withholding. While this method addresses immediate tax liabilities, the amount withheld may not always cover the employee’s full tax burden, especially if their marginal tax rate is higher than the default withholding rate. Any subsequent gain or loss from selling shares after vesting is then subject to capital gains tax. If shares are sold within one year of vesting, any appreciation is taxed at short-term capital gains rates, which are equivalent to ordinary income tax rates. If shares are held for more than one year post-vesting, any profit is taxed at potentially lower long-term capital gains rates.

Common Scenarios After Vesting

Once Restricted Stock Units have vested and shares are delivered, employees have direct ownership and several choices regarding their newly acquired assets. A common decision is to sell shares immediately to gain liquidity or to diversify their investment portfolio. Selling promptly ensures the employee realizes the value of the shares at vesting and mitigates the risk of potential stock price declines. This strategy is often recommended for those with a significant portion of their wealth tied to their company’s stock.

Alternatively, an employee might choose to hold onto shares, anticipating potential future appreciation in the company’s stock value. This decision should align with an individual’s overall financial goals and risk tolerance, considering the concentration risk associated with holding a large position in a single company’s stock. Vested RSUs can also be integrated into broader financial planning strategies, such as saving for retirement, funding education expenses, or paying down debt. Understanding company-specific trading windows and insider trading rules is important when planning to sell shares.