An Introduction to Restricted Stock Units (RSUs): What Employees Need to Know
Publicly traded and private companies often share a portion of the success with employees through equity compensation. One common method is called restricted stock units (RSUs). These can be an extremely valuable component of an employee’s compensation and a retention tool for employers. As an employee, you have many factors to consider when participating in RSUs. Understanding the vesting schedule, liquidity, and taxation is crucial for your financial journey.
“With great power comes great responsibility”—a quote that has been reformed over the centuries by presidents, prime ministers, and superhero movies. It’s also one of the ways to summarize your ideal handling of RSUs. This blog covers the components of RSUs so you can make great decisions about this potentially wealth-enhancing tool.
Vesting Schedules
Vesting schedules are a key component of restricted stock units that you want to understand. As an employee, it’s important to comprehend your company’s vesting schedule. It typically outlines how and when RSUs will become fully vested and available. The two most common vesting schedules are cliff-based and graded-based.
Cliff-based vesting awards employees their RSUs following a set time frame or if a certain milestone is achieved. Often, there is a wait period—typically one year, depending on the company terms—before restricted stock units begin to vest. Once that cliff period is over, a portion of the RSUs will vest. From there, the leftover RSUs will follow the vesting schedule.
For example, a company may offer a four-year vesting schedule with a one-year cliff. In this case, 25% of your RSUs will vest after the first year, with the remaining 75% vesting over the next three years.
The main purpose of cliff-based vesting is to incentivize employees to stay with the company for at least the initial period and may provide ongoing motivation.
Graded-based vesting is a simpler method. Employees receive a percentage of their restricted stock units each year on the grant’s anniversary date. The vesting period may vary but typically ranges from three to four years.
Let’s say you have a four-year graded-based vesting schedule; this may mean that 25% of the RSUs are vested yearly. Some companies may offer quarterly or monthly vesting after an initial cliff period. This vesting schedule allows you to vest over time and may help mitigate the impact of market fluctuations due to the predictable schedule.
Understanding your vesting schedule is crucial for financial planning and assessing the true value of your compensation package. It allows you to make informed decisions about your career and finances, considering the potential future value of your restricted stock units.
Liquidity
For public companies, you don’t own anything until the RSUs vest. When this happens, you’ll receive company shares with the caveat of paying income tax on the value.
If your restricted stock units vest during a blackout period (a time when certain executives, employees, or both are prohibited from buying or selling shares before earnings), then the shares will be released after that time frame. The reason behind the blackout period is to prevent insider trading or unethical use of insider information.
Private companies can also offer RSUs. In this case, to liquidate shares, there would need to be a liquidity event—for example, an initial public offering (IPO), acquisition, or merger. Also, some companies allow employees to find a third party to purchase their restricted stock units.
Overall, the liquidity of RSUs depends largely on whether the company is public or private. For employees of public companies, RSUs provide a clear path to owning company stock, which can be sold on the open market after vesting (subject to any company-specific trading restrictions).
For those in private companies, RSUs represent a potential future value, but the ability to convert them to cash may be limited until a significant company event occurs.
This difference in liquidity is an important factor to consider when evaluating job offers or managing your finances.
Taxation on Restricted Stock Units
Grant date: This is the date the RSUs are granted to you. There is no tax implication for the grant date. Think of it as a promise for future shares from the company. The criteria for vesting will still need to be met.
Vesting date: When RSUs vest, they are classified as ordinary income (same as salary/bonus) based on the shares’ fair market value (FMV). The amount of income will be the fair market value of the shares multiplied by the number of shares vested.
Typically, many employers handle the tax withholding by selling a portion of your RSUs to cover your tax due. The IRS requires a federal withholding rate of 22% on income up to $1 million and 37% on anything exceeding $1 million.
Sale of shares: After your RSUs vest, they will fall under capital gains and be taxed as such. It’s important to understand timelines to be as tax-efficient as possible.
Short-term capital gains: If you sell your shares less than one year after the vesting date, gains will be recognized as short-term capital gains. Short-term capital gains are taxed as ordinary income. The value of the shares on the vesting date is considered the cost basis.
Long-term capital gains: If you sell your shares after holding more than one year after the vesting date, gains will be recognized as long-term capital gains. These rates are more favorable than income rates. As mentioned, the cost basis is the value of the shares on the vesting date.
Understanding RSU tax implications is vital for effective financial planning. RSUs are subject to a multi-layered tax treatment that can significantly impact your overall tax liability. The key is to recognize that you’ll face tax obligations at two distinct points: when the RSUs vest and when you sell the resulting shares.
Key Takeaways
Restricted stock units can be a valuable part of your overall compensation package, offering a leg up in your financial journey. However, they come with complexities in terms of vesting, liquidity, and taxation that require careful planning.
Lastly, given the tax implications of RSUs, it’s often beneficial to consult with a financial advisor or tax professional. They can help you develop strategies to manage your vesting schedule, plan for tax liabilities, and help make informed insights about holding or selling your shares.
The opinion of the author is subject to change without notice and must be considered in conjunction with relevant regulation, as well as subsequent changes in the marketplace. Any information from outside resources has been deemed to be reliable but has not necessarily been verified. Each individual has unique circumstances to which this information may or may not be relevant. Under no circumstances will this information constitute an offer to buy or sell and it does not indicate strategy suitability for any particular investor.
