Restricted stock units (RSUs) is a type of compensation that is granted to employees as part of an equity incentive plan. A company’s compensation package typically includes a base salary, a cash bonus, RSUs, and stock option grants. RSUs align the interests of employees with those of the company, encouraging employees to focus on long term success of the company. Unlike stock options, which can become worthless if the company stock price drops, RSUs usually retain some value even if the company share price declines significantly. However, while RSUs are a straightforward concept, it’s crucial to understand the technical details of these grants to maximize their benefits.
Here we will provide some general information about RSUs, including their fundamental concepts, how vesting schedules work, and their tax implications according to the internal revenue code.
How RSUs work
RSU stands for Restricted Stock Unit, which is a form of equity compensation plan used by many public and large private companies to reward their employees. An RSU compensation consists of three essential components:
- RSU agreement – The RSU agreement is the document that outlines the terms and conditions of the RSU grant, including the vesting schedule and any restrictions on the stock.
- RSU vesting schedule – The RSU vesting schedule is the timeline or schedule by which RSUs granted to an employee become fully vested or transferable. This schedule is usually based on the employee’s length of service or the achievement of certain performance milestones. It usually takes a long time (e.g. four years) for RSUs to vest completely.
- RSU vest date – The vesting date is the date on which the employee becomes entitled to receive the shares of stock.
When an employee is granted RSUs, they are not immediately granted ownership of the underlying stock. Instead, the RSUs are subject to a vesting schedule, which sets out the conditions that must be met before the RSUs become fully vested.
Typically, an RSU vesting schedule will specify a period of time called “vesting period”, often several years, during which
the RSUs vest in increments. For example, a common RSU vesting schedule might provide that 25% of the RSUs vest after the first year, with the remaining RSUs vesting in equal installments over the following three years.
Once an RSU has fully vested, the employee can then take ownership of the underlying stock, or sell it in a brokerage account such as E-trade or Morgan Stanley, if they choose as long as the sale is not within a “blackout period” (where trading is prohibited) or subject to any other restriction that may limit their ability to sell. Until the RSUs are fully vested, the employee generally cannot sell or transfer them. Job termination almost always stops vesting. The only exception occurs in certain situations when vesting may be allowed to continue or may even be accelerated in case of death, disability, or retirement, depending on your plan and grant agreement.
It’s important to note that RSU vesting schedules can vary significantly from one company to another, and even within the same company, depending on the employee’s position and other factors. So, it’s important to carefully review the terms of any RSU grant to understand the vesting schedule and other important details.
Unlike stock options, RSUs always have some value to you, even when the stock price drops below the price on the grant date. Example: Your company grants you 2,000 RSUs when the market price of its stock is $22. By the time the grant vests, the stock price has fallen to $20. The grant is then worth $40,000 to you before taxes.
Tax Treatment and Implications
When the RSU vests, the employee will be taxed on the fair market value of the stock at the time of the vesting date. This is considered ordinary income and will be subject to federal and state income taxes. That income is also subject to mandatory supplemental wage tax withholding. Withholding tax, which for U.S. employees appear on Form W-2 along with the income, include the following:
- Federal income taxes
- Social Security and Medicare
- State and local taxes, when applicable
A company may offer a choice of ways to pay taxes at vesting, or it may use a single mandatory method. The most common practice is taking the amount from the newly delivered shares by surrendering stock back to the company. This holds shares to cover the taxes under a net-settlement process, and company cash is used for the payroll tax deposit.
When you later sell the shares, you will pay capital gains taxes on any appreciation over the market price of the shares on the vesting date. If you hold shares longer than one year from the vesting date, any gains upon selling those shares will be taxed as a preferential long-term capital gains. If you hold those same shares for one year or less after the vesting date, ordinary income tax rates may apply upon selling. When making a decision about when to sell your company’s shares, it’s important to take into account how much of your overall net worth is tied to the fortune of a single company. This is referred to as single stock risk, or concentration risk, which means that your investment in the company’s stock may be disproportionately high compared to your other assets in your investment portfolio.
The Bottom Line
It is always important to consult with your financial advisor or tax advisor to seek the right investment, legal and tax advice when it comes to RSUs, as the tax consequences and the terms of the agreement can vary depending on the company and your personal financial situation.