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What Are Restricted Stock Units (RSUs) and How Do They Work | Plancorp

Written by Brian Watson | July 3, 2024

Employers grant restricted stock units (RSUs) for various reasons: outstanding performance, tenure, company milestones, or simply as a token of appreciation to drive employee retention, but often there is minimal guidance on what these are or how to build them into your financial plan to maximize the impact on your bottom line and goals.

I want you to try visualizing a puzzle with only one or two pieces. While individually interesting, it doesn't quite make sense! Similarly, looking at RSUs as stand-alone assets can lead to problems. Rather, you need to view them as just one piece of your total financial puzzle.

This article goes into various features, advantages, drawbacks, and recommendations for RSUs so you can feel confident in your ability to maximize these benefits!

What Are Restricted Stock Units?

RSUs are a form of equity-based compensation. Essentially, your employer makes a promise to pay you in the form of company stock at a future date, if certain conditions are met—usually, that you remain an employee for a set period or achieve certain goals. They are referred to as restricted because of these stipulations making them not immediately available to you today. When these conditions are met, the shares become available to you, which is referred to as vesting.

For companies, RSUs are straightforward. They offer a way to motivate and retain top talent without immediately diluting shares or paying out cash.

For you, as an employee, RSUs also have a clear benefit: a financial reward that could appreciate in value over time. This should, in theory, incentivize you to perform well and stay with the company.

Before we dive into how RSUs work and what their role should be in your portfolio, let’s explore the mechanics.

Key RSU Terms to Know

  • Grant Date: The date when your company shares with you the details of the RSUs they are giving to you and outlines information for their vesting.
  • Vesting Schedule: An outline of the milestones you must reach for your shares to transfer to your ownership.
  • Vesting Date: The date when your shares fully vest, meaning your shares are no longer “restricted” and you have ownership of them.
  • Fair Market Value (FMV): The value of the stock as determined by the market or an independent valuation at a specific point in time.
  • Forfeiture: The loss of unvested RSUs because of failing to meet vesting criteria, such as leaving the company prior to your vesting date.

Types of Restricted Stock Units

Generally, companies structure RSUs in one of three ways: time-based, performance-based, or a combination of the two.

Time-based RSUs require you to stay at the company for a predetermined period (e.g., four years) before your shares fully vest.

Performance-based RSUs (sometimes called PSUs) are tied to specific company performance milestones, such as going public via an IPO, being acquired, reaching department specific metric goals, or completing a major project.

When RSUs have one restriction, like time elapsing or a liquidity event occurring, they are considered single-trigger RSUs. When they have two restrictions, like time elapsing and a liquidity event occurring, they’re known as double-trigger RSUs.

For instance, a non-publicly traded company may offer RSUs with two vesting requirements, requiring four years of employment and also requiring an exit event (company acquisition or going public).

How Do Restricted Stock Units Work?

Stock is in the name, but RSUs don’t function like common stock — you can’t trade or transfer them, and they typically don’t provide voting rights or entitle you to dividends. Until your vesting date, you can think of RSUs as a pending promise, nothing more.

RSU vesting schedules vary but generally fall into the following categories:

  • Cliff vesting: All granted shares are delivered at once.
  • Graded vesting: You become vested in portions of the granted shares over regular intervals.
  • Hybrid vesting: Your employer may offer a mix of cliff and graded vesting. For example, they may grant shares that vest over four years, with 25% vesting after the first year and the rest vesting in equal monthly installments over the next three years.

While RSUs have an estimated value at the time of grant, the actual value to you depends on the fair market value (FMV) of your shares when they vest.

Let’s look at an example: Emmitt is offered a compensation package of $300,000 in salary and a grant of $50,000 in equity compensation via RSUs, vesting annually over the next 4 years in equal increments.

If the share price is higher than $25 at the vesting date, the value of Emmitt’s actual compensation increases. Similarly, his compensation decreases if the share price declines by the vesting date.

If the FMV on the grant date is $25 a share, then this would equate to 2,000 shares, with 500 shares vesting each year.

If the FMV is $50 upon vesting, Emmitt’s annual cash and equity compensation is estimated at $325,000 for this year.

If the FMV is $10 upon vesting, Emmitt’s annual cash and equity compensation is estimated at $305,000 for this year.

The reason it's important to understand your vesting schedule and the fair market value when those shares fully vest is because of how it will influence your taxable income in that given year. 

Tax Implications of Restricted Stock Units

There is no tax at the time of grant since the shares are not technically yours yet. But as you might guess, the IRS does eventually take its cut.

  • Upon vesting: When your RSUs vest, the FMV of the shares is treated as ordinary income and taxed as if you had received the same amount in cash compensation. Even if you do not sell them, the share value is subject to federal, payroll (Social Security and Medicare), and applicable state and local taxes for that year.
  • Upon sale: Once vested, shares can usually be sold at the employee’s discretion (be careful of company enforced selling restrictions, often referred to as blackout windows). Any change in value from the vesting price is considered a capital gain or loss for tax purposes. (Note: If you vest and then immediately sell your shares, it stands to reason that you incur minimal gain or loss.)

To understand the tax ramifications, let’s continue with Emmitt’s example.

Emmitt is expecting 500 RSUs to vest shortly. Assuming his company stock is trading at $25 per share when they vest, he owes ordinary income tax on $12,500 (500 x $25) that year.

If Emmitt sells the shares immediately after vesting at $25 per share, there is no capital gain or loss tax for him on top of that.

If he sells the shares for a gain or loss in the future, this gain or loss will be taxed at the appropriate capital gains tax rates (either short-term or long-term, depending on the holding period).

Since the value of the vested shares is treated as ordinary income, RSUs are subject to mandatory supplemental wage withholding for federal income tax purposes. That’s 22% on the first $1 million of supplemental wages and 37% once it exceeds $1 million in a calendar year. State tax rules vary, but they often have their own mandatory tax withholding rules.

Your actual tax liability on RSU income can be much different than these standard withholding rates. If you underpay, you risk incurring tax penalties. If you overpay, you might be giving the government an interest free loan. As such, you may want to consider having a tax projection run to determine the appropriate amount to either have withheld or to pay as estimated taxes.

Most companies default to what’s known as a sell-to-cover strategy upon vesting, immediately selling a certain number of an employee’s vested shares to cover the tax liability. This typically covers the federal, state, and payroll taxes.

However, companies are now starting to implement withhold-to-cover as an option as well. This is often beneficial to the employer since they simply retain shares and can pay the tax amounts you outline out of their own cash, decreasing share dilution.

Withhold-to-cover is usually a pro for the employee as well since a fixed tax amount will be paid, avoiding under/overselling of shares. Since with sell-to-cover, the shares are sold on the open market, they might fluctuate in price causing more or less to be paid for taxes than desired.

Brokerages also often force shares to be sold in whole units, no partial shares, so when the tax amount falls in between the amount you can sell whole shares for, shares might be oversold or undersold (i.e. you want $100 withheld for taxes, but the current share price is $90, 2 shares will be sold for $180, with the remaining $80 coming to you as a cash payment).

If you are compensated in restricted stock units and do not have a financial advisor today, it may be beneficial to hire one to ensure you're maximizing the positive impact of this compensation without the headache of managing it yourself. Along with the other benefits that come with hiring a wealth manager, RSU tax strategy is a key benefit and a sign that you have likely outgrown DIY approaches. If you already have an advisor and they aren't talking to you about proactive tax projections to streamline your tax liability, it might be time to shop around. Check out our advisor interview guide for more details on what to ask.

Advantages of Restricted Stock Units

Simple and flexible. RSUs follow a set vesting period, making them fairly simple and easier to understand compared to other types of equity compensation like employee stock purchase plans (ESPP). You don’t have to worry about strike prices or when to exercise. Moreover, once RSUs vest, they are yours even if you leave the company.

No upfront purchase. Unlike stock options, RSUs don’t have to be purchased upfront, they are granted by the employer at no cost to the employee. In short, you benefit without any initial financial commitment or risk, they are simply a form of deferred compensation. 

Value retention. RSUs still hold value even if the company’s stock falls, whereas stock options only hold value if they’re “in the money” (current FMV is greater than strike price). As long as the share price doesn’t fall to $0, you only stand to gain from RSUs.

Drawbacks of Restricted Stock Units

Tax liability. Financial rewards are great, but they also mean taxes will be involved. RSUs are taxed as ordinary income at their fair market value upon vesting, which can lead to a substantial tax burden if many shares vest simultaneously and you haven't planned ahead. This can be particularly problematic if the stock's value decreases after vesting but before the actual shares are sold, leading to paying income taxes on an amount higher than you’re able to sell the shares for.

Portfolio concentration. Diversification is key to a balanced portfolio, and RSUs can lead to a significant concentration in your employer stock. While that can pay off if your company is successful and growing, there is an equally consequential downside. Your financial well-being can become too closely tied to one company's performance, putting you in unnecessary risk if the company runs into financial difficulties or the share price sags.

Private market illiquidity. For employees of private companies, an additional drawback of RSUs is their dependency on liquidity events to realize value. Unlike public companies, whose stock can be sold relatively freely, the value of RSUs in private firms is typically only realized through specific events, such as an IPO, acquisition, or tender offers.

Debunking Myths: Why Holding Vested RSUs Is Not Beneficial

We typically see employees hold RSUs after they vest for two inaccurate reasons. First, they mistakenly think there are tax advantages to holding RSU shares after they vest. The truth is: There is no unique tax benefit to holding shares beyond the vesting date.

As described above, RSUs are almost always taxed as income in the year they vest. In other words, whether Emmitt receives $300,000 in salary, or a combination of salary and RSUs, the tax liability is similar.

Unlike with ESPP shares, you cannot reduce this base tax liability by holding onto vested RSU shares. If the shares appreciate or depreciate before they are sold, the tax on that change (long-term or short-term capital gain) can be changed by retaining the shares just like normal stock.

The second misleading reason people hold vested RSUs is the natural human tendency to overvalue things already in our possession—a behavioral bias called the endowment effect.

Would you use all a $50,000 cash bonus to buy your employer’s stock? If the answer is no, then you are likely exhibiting the endowment effect. These RSU grants/vestings are taxed as if your employer just paid you a specific dollar amount of cash, and we’d encourage you to think about these with this lens. How can that set value be most beneficial to your diverse investing strategy?

Selling Restricted Stock Units: Making the Right Decision

So, when should you hold or sell your vested RSUs? Rather than be swayed by faux tax implications or biased behavioral logic, the actual answer depends on 2 key factors:

  1. Your financial goals
  2. Your current portfolio allocations.

Aligning RSUs with Your Financial Goals

Because RSUs typically vest in predictable chunks, it’s natural to view RSUs as a bonus that can be used to fund a future goal or expenditure. But once the shares vest, pay close attention to when you will need to liquidate them.

It’s risky to hold a large sum of money that you need soon in a volatile investment like a single stock. If the stock price falls, it puts your goal in jeopardy.

If you’re accumulating assets you plan to spend in the next year or two, retaining your RSUs may not be the best decision. As an aggressive and risky investment, RSUs (individual stocks) are misaligned with dependably paying for short-term goals.

It may be more appropriate to allocate a small part of your portfolio to your company stock for long-term goals like retirement or general wealth accumulation. Even then, we suggest ensuring the allocation fits into your globally diversified equity portfolio, as we discuss below.

Incorporating RSUs into Your Overall Portfolio

RSUs are a slice of, but not the entire pie. In the same sense, RSUs should be one part of a larger portfolio strategy. If your goal is to achieve efficient risk vs. reward balance, you should likely sell vested shares and reinvest the proceeds in a diversified portfolio.

If you want to accumulate more of your company stock by holding vested shares, it’s a good rule of thumb to limit this holding to no more than 10% of your overall liquid net worth. That’s because a concentrated position in any one stock poses an unnecessary investment risk.

Here's the hard truth: most individual companies underperform in the market as a whole over the long run. Even worse, 4 in 10 stocks have shown to eventually suffer a permanent decline of 70% or more from their peak value. Employees at each of those companies that retained shares thought their company would never be one of those, but it's a reality you can't always control but you can prepare for with smart diversification.

It’s common to see employees build a concentrated position in their employer’s stock because of their emotional investment in the company. After all, you’re often well informed about your employer’s operations, and hopefully you feel confident about its future with the hard work you are putting in each day!

Unfortunately, familiarity does not mean you know exactly what the future holds. In fact, familiarity often causes employees to overweight the positives and downplay the risks—another behavioral tendency known as confirmation bias.

It’s helpful to remember that a considerable percentage of your financial well-being (income, career development, retirement and health care benefits) is also tied to your company, so your total company-specific risk goes beyond just the stock price. Partnering with an independent financial advisor can help you overcome these logical fallacies to plug in the individual pieces of the puzzle into a balanced and cohesive financial strategy. 

Also, recall this is not a set it and forget it situation. It is advisable to revisit your RSU strategy if you are retaining vested RSUs while already having a concentration of your wealth tied to your company’s future. You might be succumbing to a couple of behavioral biases with compounding impacts as your holdings grow.

Financial Planning for RSUs

Owning a vested stake in your company through RSUs can be a great win for both you and your employer. However, if you don’t enter this phase of your career with thoughtful, rules based liquidation plan, you can potentially expose yourself to risks and inefficiencies along the way. You can protect yourself from this by building a tax-wise plan based on your overall financial goals and broader investment portfolio.

Managing your vested shares in the context of your greater goals gives you the best odds for ensuring all the pieces in your life’s puzzle fall into place as planned!

If you’ve been surfing the waves of equity compensation on your own, you don’t have to. Now might be the time to work with a knowledgeable partner who deals with this day in and day out to make sure you are optimizing these benefits to their fullest.

As we mentioned at the start of this article, RSUs are just one piece of a larger financial puzzle. Make sure you have the right support on your side to manage the complexities of equity compensation. Our 2-minute money match quiz will pair you with the right type of help.