What Are Restricted Stock Units (RSUs)?

Restricted Stock Units (RSUs) have become a significant component of employee compensation, particularly within the technology sector and for publicly traded companies. This form of equity compensation helps companies attract and retain talent by aligning employee interests with those of shareholders. RSUs serve as an incentive, motivating employees to contribute to the company’s long-term success and stock value. Their increasing prevalence highlights a shift in compensation strategies, moving beyond traditional salaries and bonuses to include equity-based rewards.

Defining Restricted Stock Units

Restricted Stock Units represent a promise from an employer to grant an employee shares of company stock, or the cash equivalent, once specific conditions are met. These units are “restricted” because employees do not own the shares when initially granted. The grant date outlines the number of units promised and the conditions for their eventual release. Unlike traditional stock options, RSUs typically hold inherent value from the grant date, as they represent actual shares to be received.

The “restricted period” refers to the time frame during which ownership conditions must be fulfilled. During this period, the employee cannot sell, transfer, or otherwise control the RSU shares. This restriction incentivizes continued employment and performance. Once these conditions are satisfied, the restrictions lapse, and the RSUs convert into actual shares, which are then delivered to the employee.

Key Stages of RSU Ownership

The journey of a Restricted Stock Unit involves distinct stages, primarily focusing on vesting and subsequent distribution. Vesting refers to the process by which an employee gains full ownership rights to the RSUs. This process depends on meeting predefined conditions, most commonly continued employment over a specified period.

Common vesting schedules include “cliff vesting,” where all RSUs vest at once after a fixed period, such as one year of employment. “Graded” or “ratable vesting” involves RSUs vesting in increments over several years, for example, 25% each year over four years. Some RSU agreements may also include performance-based conditions, requiring the achievement of specific company or individual metrics. Once the vesting conditions are met, the RSUs are no longer restricted.

Upon vesting, the RSUs move to the settlement or distribution stage, converting into actual shares of company stock. These shares are then transferred to the employee’s brokerage account. This conversion may occur immediately upon vesting or shortly thereafter, depending on the company’s administrative processes. For instance, some companies might settle all vested RSUs on a specific day each quarter.

After the shares are distributed, the employee has several choices. They can hold onto the shares, becoming a direct shareholder, or sell them immediately. The decision to hold or sell often depends on individual financial goals, diversification strategies, and tax considerations, which become relevant at this point.

Taxation of RSUs

The taxation of Restricted Stock Units is a significant consideration for employees, occurring at two primary junctures: vesting and subsequent sale. When RSUs vest, their fair market value on the vesting date is treated as ordinary income to the employee. This amount is added to the employee’s regular wages and is subject to federal income tax, Social Security tax, and Medicare tax, similar to a cash bonus. This income is reported on the employee’s W-2 form for the year in which the vesting occurs.

Employers withhold a portion of the vested shares or their cash equivalent to cover these tax obligations. For federal income tax, the supplemental wage withholding rate is 22% for income up to $1 million, and 37% for amounts exceeding $1 million. This withholding rate may not fully cover an employee’s total tax liability, especially if their overall income places them in a higher marginal tax bracket. Employees may need to adjust their tax withholdings or make estimated tax payments to avoid underpayment penalties.

If an employee sells their vested shares, any gain or loss from that sale is subject to capital gains tax. The cost basis for these shares is their fair market value on the vesting date. If the shares are sold immediately upon vesting at the same fair market value, there is no additional capital gains tax. However, if the shares are held and their value appreciates, the difference between the sale price and the cost basis (fair market value at vesting) is considered a capital gain.

The capital gains tax rate depends on the holding period after vesting. If the shares are sold within one year of the vesting date, any profit is considered a short-term capital gain and is taxed at the employee’s ordinary income tax rate, which can range from 10% to 37%. If the shares are held for more than one year after vesting, any profit is classified as a long-term capital gain and is taxed at more favorable rates, specifically 0%, 15%, or 20%, depending on the employee’s taxable income. Conversely, if the shares are sold at a loss, that loss can be used to offset other gains or a limited amount of ordinary income.