What Is a Restricted Stock Unit (RSU)?

Understanding Restricted Stock Units

A Restricted Stock Unit (RSU) represents a promise from an employer to grant shares of the company’s stock to an employee at a future date. This form of equity compensation has become a common component of remuneration packages. RSUs are designed to align employee interests with the company’s long-term success and to incentivize continued employment.

Restricted Stock Units are a type of compensation where an employee is awarded units that represent a specific number of company shares. These units are not actual shares at the time of the grant; instead, they are a contractual right to receive shares once certain conditions are met. The employee does not own the shares, hold voting rights, or receive dividends until these conditions are satisfied. This arrangement means RSUs have no tangible value to the employee until they vest.

The process begins on the “grant date,” which is when the company formally awards the RSUs to the employee. On this date, no shares are actually transferred, and the employee does not incur any tax obligations. The RSUs remain restricted and subject to forfeiture until the specified conditions are fulfilled.

The next phase is “vesting,” where the restrictions on the RSUs are lifted, and the employee gains full ownership of the underlying shares. Vesting occurs based on specific criteria, most commonly continued employment for a set period, known as time-based vesting. For instance, a common schedule might see a portion of the RSUs vest annually over several years, such as 25% each year over a four-year period.

Some RSU grants may also include performance-based vesting, requiring the achievement of specific company or individual performance targets. Once the vesting conditions are met, the shares are delivered to the employee’s brokerage account.

Tax Implications of RSUs

When Restricted Stock Units vest, their fair market value on the vesting date is treated as ordinary income for the employee. This income is subject to federal income tax, Social Security, and Medicare taxes, similar to regular wages. State and local income taxes may also apply. This means that even if the employee does not sell the shares immediately, a tax liability is incurred at the time of vesting.

Employers manage the initial tax withholding associated with RSU vesting. This often involves a “sell-to-cover” mechanism, where a portion of the vested shares is automatically sold to cover the required tax withholdings. This process ensures the employee’s tax obligations are met at the source without requiring them to use personal funds.

The income recognized from vested RSUs, along with the corresponding tax withholdings, will be reported on the employee’s W-2 form for the year in which the vesting occurs. This inclusion can increase an employee’s taxable income, potentially pushing them into a higher tax bracket. The fair market value of the shares on the vesting date establishes the “cost basis” for those shares for future capital gains calculations.

Post-Vesting Considerations

After RSUs vest and the shares are delivered, employees have control over their newly acquired company stock. At this point, employees have two primary options: holding the shares or selling them. Holding shares means the employee retains ownership, allowing for potential future appreciation in value, but also carries the risk of depreciation if the stock price declines.

Shares can be sold immediately upon vesting or at a later date. If shares are sold immediately at the fair market value established at vesting, there is typically no additional capital gain or loss, as the primary tax event for the initial value has already occurred at vesting as ordinary income.

If the shares are held for a period after vesting and then sold, any difference between the sale price and the cost basis (the fair market value on the vesting date) will result in a capital gain or capital loss. The tax treatment of this gain or loss depends on the holding period. Shares held for one year or less after the vesting date are subject to short-term capital gains tax rates, which are equivalent to ordinary income tax rates. Shares held for more than one year after vesting qualify for long-term capital gains tax rates, which are lower than ordinary income tax rates.