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Restricted stock units (RSUs) are a form of employee compensation that grants shares of a company’s stock to employees. They may be granted to employees as a reward for performance, length of service or some other reason, or simply as an incentive to remain with the company. RSUs provide employees with the opportunity to benefit if the company performs well and the stock price increases.

Here’s how RSUs work, the pros and cons and the tax implications.

How RSUs work

A company grants RSUs to employees and often distributes them over a period of time with a vesting schedule or other requirements. Employees don’t have to pay anything to receive RSUs and are responsible for taxes only when they actually receive them; in other words, when they vest.

Vesting is a process where RSUs must meet certain conditions set by the employer, such as staying with the company for a specified duration or achieving performance milestones, for example. Once the conditions are met, the RSUs vest, and the employee receives the shares. RSUs may have additional vesting conditions beyond the vesting period.

For example, a company may grant 300 RSUs that vest over three years, so each year the employee receives 100 shares of the stock. A year after the grant date, the employee would own 100 shares of the stock, with 200 shares remaining unvested. After each subsequent year of employment, a further tranche of RSUs vests, until the employee owns all 300 shares.

RSUs are an alternative to stock options as compensation. Unlike traditional stock options, which may end up worthless if the stock price declines too much, RSUs still have value even if the stock price decreases, unless it declines to zero.

Once RSUs are vested, they are treated the same as if you had purchased company shares on the stock market. You can keep the shares or sell them. If you choose to sell, you could reinvest the money, open a savings account or set up a retirement account to enjoy tax-deferred growth.

When do RSUs vest?

The vesting period is the length of time between being granted RSUs and when you actually own the shares and can sell them. The vesting period can last for several years, depending on the exact conditions of the grant, though some RSUs may vest immediately on the grant date. If an employee’s job is terminated, vesting typically stops unless stipulated otherwise, for example, in an early retirement offer.

The vesting schedule determines when the RSUs become tangible shares that the employee officially owns. It’s often based on the length of employment or certain performance goals. For example, if you receive 10,000 RSUs and the vesting schedule is four years, 2,500 shares would vest each year on the anniversary date of the grant. If the company has a liquidity event, such as an initial public offering (IPO), before the vesting schedule is complete, the RSUs may vest, depending on the exact terms of the RSU grant or other subsequent agreements. Once RSUs are vested, the employee can receive actual shares of stock or, if stipulated in the grant, the equivalent value in cash.

Benefits of RSUs

Here are the advantages of RSUs:

  • RSUs offer employees the opportunity for financial gain if the company performs well and the stock price increases.
  • Unlike traditional stock options, which may require employees to pay upfront to receive the actual stock, RSUs do not require employees to pay anything upfront to receive the stock.
  • Taxes are typically paid only when the shares are received.
  • RSUs can be used to reward and incentivize employees, and may help management retain employees over a longer period.

Drawbacks of RSUs

Here are the disadvantages of RSUs:

  • RSUs typically only pay dividends once they are vested.
  • When RSUs vest, their full value must be reported as regular income for tax purposes, potentially bumping you up into a higher tax bracket.
  • RSUs do not confer voting rights until actual shares are received.
  • If you leave the company before your RSUs vest, you typically forfeit any unvested units, and you may have to resell even vested stock to the company.
  • Additional vesting conditions may apply, such as if the company makes an acquisition or undertakes an IPO, and these can determine when RSUs vest and become available to you.

How RSUs and taxes work

When you are granted restricted stock units, you are not immediately taxed. Instead, you become liable for taxes only when the shares vest and you receive them. You must report the value of any vested shares on your taxes.

In most cases, this additional compensation will be automatically reflected on your W-2 and taxed as earned ordinary income. When you receive RSUs, typically your company will automatically withhold federal, state and local taxes, using a portion of your shares to pay for them. However, some firms may let you pay taxes out of your own pocket or even borrow from the company to pay taxes, allowing you to continue to hold the full stock grant and enjoy any additional upside.

If you decide to sell your stock later after having paid taxes on the vested shares, you are not taxed on the full value of the stock. You are taxed only on any incremental gains in the stock or loss. If it is a loss, it can count against other capital gains.

For example, imagine you received stock worth $10,000 and paid taxes on it, and then the value rose to $15,000 and you decided to sell. You would owe capital gains taxes on only the increased value of the stock ($5,000) and not the entire value of the stock ($15,000).

RSUs are not eligible for the IRC 83(b) election, as they are not categorized as tangible property by the IRS. This election allows some individuals the ability to pay taxes on RSUs at their grant date, potentially saving them a lot on taxes if the stock appreciates significantly later on.

Bottom line

Restricted stock units can be an attractive form of equity compensation for employees, as they do not require upfront payment and allow employees the ability to enjoy in the success of a business. However, employees should be aware of the vesting schedule and the tax implications once shares vest.