What Does It Mean When a Stock Is Vested?

Stock vesting is a common employee compensation mechanism, particularly in companies offering equity. It’s the process where an employee gains full ownership of equity awards, like stock options or restricted stock units (RSUs), after meeting specific conditions. These often involve a period of employment or achieving certain milestones. Vesting ensures employees earn equity over time, aligning their long-term commitment with company success.

Understanding Stock Vesting

Companies utilize stock vesting as an incentive to retain employees and align their interests with the organization’s growth. Granting equity that vests over time encourages employees to remain dedicated and contribute to long-term objectives.

Two common types of vesting schedules are “cliff vesting” and “graded vesting.” Cliff vesting grants full ownership of a block of shares only after a specific period, such as one year, has passed. For example, in a four-year vesting schedule with a one-year cliff, an employee receives no vested shares during the first year, but after completing 12 months, 25% of their total grant vests at once. After the cliff, the remaining shares typically vest incrementally, often monthly or quarterly, over the subsequent years until the full grant is owned.

Graded vesting, in contrast, allows employees to earn ownership incrementally over a set period, with portions of the equity vesting at regular intervals. For instance, an employee might vest 20% of their shares each year over a five-year period, with ownership gradually increasing. If an employee leaves the company before their stock fully vests, any unvested shares are typically forfeited and revert to the company.

Implications of Vested Stock Ownership

Once stock has vested, it signifies that the employee has gained full legal ownership and control over those shares. Unlike unvested shares, which are conditional and still subject to forfeiture, vested shares belong entirely to the employee. Unvested shares cannot be sold, transferred, or used for financial benefit until the vesting conditions are met. This ownership grants the individual several new rights and choices.

With vested stock, an employee can typically sell the shares, hold them as an investment, or, if applicable, exercise voting rights associated with common stock. The ability to sell provides liquidity, allowing the employee to realize financial gains from their equity compensation. The decision to sell or hold depends on individual financial goals and market conditions.

Taxation of Vested Stock

Vesting is generally considered a taxable event for the employee. When stock or restricted stock units (RSUs) vest, the fair market value (FMV) of the shares on the vesting date, minus any amount the employee paid for them, is typically treated as ordinary income. This income is subject to federal, state, and payroll taxes, including Social Security and Medicare, similar to regular wages. The taxable amount is usually reported on the employee’s W-2 form.

For example, if 100 shares vest when the stock is trading at $50 per share and the employee paid nothing for them, the employee would recognize $5,000 of ordinary income. Taxes on this amount are often withheld by the employer, sometimes through a “sell-to-cover” method where a portion of the vested shares is sold to cover the tax obligation.

If the vested stock is held after the vesting date and subsequently sold, any appreciation or depreciation in value from the vesting date to the sale date results in a capital gain or loss. This capital gain or loss is taxed separately from the initial ordinary income recognized at vesting. The tax rate for capital gains depends on how long the shares were held after vesting. Gains on shares held for one year or less are typically taxed as short-term capital gains at ordinary income rates. Those held for more than one year are taxed as long-term capital gains, which often have more favorable rates.