Restricted Stock Units Explained

Does your company value its employees? 👔

It probably does, motivation and loyalty among employees is what makes or breaks a business after all—a good enough reason to keep those high achievers around. Nevertheless, many—especially millennial—employees are always on the lookout for better opportunities.

Unsurprisingly, companies want to keep valued employees around—and they have a couple of tools at their disposal to make staying more attractive.

With the Covid-19 pandemic having exacerbated the “job-hopping’’ phenomenon—a quarter of the workforce was looking to switch jobs in February 2021—all the more reason for companies to incentivize employees to stay loyal and align their employees’ goals with their own.

Restricted stock units are a useful way of compensating employees to achieve all this and can also entice potential new employees to come aboard. This type of restricted stock can be hugely beneficial to both employees and employers—if used in the right way. 

Both parties need to know exactly what it is they’re dealing with to avoid making mistakes. Like with many financial products, there also needs to be a strategy in place to optimize the potential returns of the RSUs.

To make you feel comfortable dealing with RSUs, we’ll tell you everything you need to know. In this article, you will learn what they are, how they work, what their advantages and downsides are, and how they are taxed. We’ll also give you a few useful selling strategies and compare them to stock options. 

What Exactly are Restricted Stock Units? 💡

There are many ways an employer can choose to compensate employees—a salary being the most obvious one. Others include benefits such as health insurance, paid leave, and many others—sometimes even free coffee if you’re really lucky. 

One way of compensating employees is through restricted stock units—they normally come in a compensation package together with other benefits. 

A Promise of Value 🤝

With the stock market setting record after record—with only a brief bear market at the start of the Covid-19 epidemic—since the financial crisis, this type of stock-based compensation can be a very attractive proposition for employees.

Restricted stock units are a promise by the employer to give the employee shares in the company when he or she has been with the company for a specified amount of time or when a certain milestone is achieved.

They are used by employers to incentivize current employees to stay at the company and they’re part of the benefits package offered to new talent. With RSUs, employees share in the success of the company—motivating them to deliver good work.

RSU History in a Nutshell 📖

To understand the history of restricted stock units, it’s important to know what stock options are. RSUs became a popular alternative to stock options at the beginning of the 21st century—but how did stock options come about? 

Stock options were invented in the ’70s as an instrument to motivate employees and keep venture capitalists happy. The high-tech sector was growing rapidly and stock option compensation was seen as beneficial for the many start-ups sprawling up at the time. 

Fast forward to the early 21st century and we see that stock options played a major role in a variety of infamous scandals. Tax evasion and malpractice generally don’t improve a company’s reputation and soon enough stock options became a target for regulators. 

The IRS instituted new rules making stock options less attractive and new accounting rules came into existence—with courtesy of the Financial Accounting Standards Board (FASB). Enough reason for companies to start looking for alternatives. 

Since then, RSUs have been gaining in popularity and are widely considered to be a more effective tool for keeping and attracting employees. What used to be only available for top-level management, is now something commonly offered to everyday employees.

How Do RSUs Actually Work? 🤔

When the restricted stock units are issued there aren’t actually any shares given to the employee. This means that the employee hasn’t received any value just yet—this only happens when the company distributes the shares to the employee.

Get Your Vest On 🦺

The distribution of shares to an employee is done according to a specific schedule. The time an employee is waiting to receive the shares is called the “vesting period”. In other words, shares are being earned by staying at the company over time. 

This period usually lasts 4 years, but that doesn’t mean an employee has to wait all that time to receive any shares. Different batches of shares “vest”—are awarded to the employee—at different times. 

When all the shares have been distributed, the employee is “fully vested’’. How many shares the employee will receive and exactly when they will be distributed is decided by the company plan and company policy. 

Before receiving any shares at all, an employee has to reach a “vesting cliff”—no shares will be distributed until the one-year anniversary. That’s usually when a quarter of the shares are issued and the remaining shares will be distributed periodically—usually every month. 

What if the Ship Starts to Sink? 🚢

That all sounds great, but what happens if a company falls on hard times? Even though we wish it would just go up in a straight line, the stock market is a volatile place and anything can happen.

The next stock market correction or crash is always looming around the corner and could also affect your company’s share price. Whether it’s due to bad management or market circumstances, bankruptcy is also not out of the question.

The good news is that restricted stock units—unlike stock options—do retain value when the share price dips down below the grant price. The grant price is the share price at the time the restricted stock units are issued to an employee. 

The bad news is that in case of bankruptcy restricted stock units can become completely worthless. It’s possible to claim some of the company’s remaining money, but RSU holders are treated just like any other shareholder (as was the case in the Lehman Brothers debacle) and they do not have priority. 

The Upsides and Downsides of RSUs 🔍

There are many different types of stock-based compensation and each of them has its pros and cons. The points we’ll discuss in this section are crucial to whether a company decides to offer RSUs to its employees. 

What’s so Good About RSUs? ✅

The main advantage of RSUs is that they incentivize employees to stick around and perform well—the company’s success will increase the value of its share price after all. In contrast to some other types of equity compensation, the shares RSUs promise are sure to have value when distributed.

Do you hate keeping books? So do companies—luckily, RSUs can make their accountants’ lives a little bit easier. Since there are no actual shares given to the employee when the RSUs are issued, there are no shares the company has to track and record.

This also leads us to the next advantage for companies—no shares being issued until completion of the vesting schedule means that there is no immediate dilution of shares. Dilution of shares happens when new shares of stock are issued by the company.

This reduces the stake of current shareholders in the company—the more shares, the smaller percentage of ownership each share represents after all. By using RSUs a company can delay the dilution to a future date. 

What are the Downsides? 🚨

Many investors own stocks for the passive income they receive through dividend payments. Unfortunately, RSUs don’t pay any dividends since there aren’t any shares until the RSUs vest.

It changes when the RSUs vest and the employee gets the shares—then dividends will be paid out as with any other dividend-paying stock. During the vesting period, an employer can choose to pay dividend equivalents—mainly for tax purposes.

Regardless of whether you buy your shares through a good investment app or get them via a RSU program, once you own shares you own a small piece of a company. This also means that—in most cases—you have a say in what happens at the company. 

Another downside of RSUs is that they lack these “voting rights”. Just like with dividends, they will come once the actual shares are distributed to the employee.

No Taxes Just Yet 💵

Restricted stock units are not considered to be tangible property by the IRS and thus are ineligible for something called “IRC 83(b) Election”.  This arrangement allows recipients to pay taxes on equity compensation after it is granted.

Since the company doesn’t transfer any property until the RSUs vest, the RSU holder has to wait until the vesting date to pay taxes—a date to look forward to.

What to Do After RSUs Have Vested 📨

Once the RSUs have vested, the employee has a variety of options to choose from. What the best option is, depends on a person’s unique situation. One option is of course to sell the shares, but that doesn’t always have to be the best approach. 

Pulling the Trigger 🔫

Let’s say you’re the one receiving the shares—you receive shares at a fair market value when the RSUs vest. The stock has been on a tear for a long time and it’s valued way above its historical average. 

You could hope for the share price to appreciate more, but in this case, it might be a wise decision to take some chips off the table. The same goes for when you’re convinced the share price is bound to drop.

You don’t have to sell the shares all at once—a common approach is to sell only a portion and keep some of those well-earned shares. This is especially useful when you want to keep shares in the company, but don’t want your portfolio to become too concentrated.

Diversification 🧺

That’s how we get to diversification—holding on to too many shares after RSUs have vested can make for a very concentrated stock portfolio. It might be a good idea to diversify away from the company shares and allocate the money to different assets. 

When a lot of your money is tied up in company stock and you—unless you work for free—rely on them for income, you get hit by a double whammy when the company is going through a rough patch. 

To help with selling portions at a time, individual strategies—often with a financial advisor’s help—can be developed, so that there’s a system in place to systematically sell shares. This can help an investor to minimize taxes and gradually become more diversified. 

Holding On 📈

Of course, keeping all the shares is also an option—your company could be the next to have a successful IPO, for example. Or maybe the company’s stock is already a steady performer and you expect it to continue. 

Holding on to the shares may also make sense tax-wise since long-term capital gains tax is lower than short-term capital gains tax (you pay much less tax if you’ve held on to a stock for over a year). Whatever the decision may be, it’s always good to keep in mind that RSUs are compensation and should be treated as such. 

How to Pay Taxes on RSUs? 👮

On to everyone’s favorite topic—paying taxes. Just like with any other financial product, we have to keep the taxman in mind when talking about stocks. Paying taxes on RSUs works a little differently than with many other stock-based compensation options—taxes aren’t paid until vesting, after all.

To avoid running unnecessary risks or pulling out your hair trying to figure out how to report taxes on RSUs, we’ll go over the reporting process, tax withholding, and what non-U.S. employees should look out for. 

How to Report RSU Taxes 📜

When we think of taxes, we think of forms—and it’s no different this time. When dealing with RSU taxes, the W2 form is the one we need to look at. On the W2 form, we find an overview of an employee’s wages and the amount of taxes withheld in a particular year. 

Federal and state income taxes are filed with this form and companies have to send it to the IRS and their employees each year. RSUs are automatically reported on the W2 because they are—in essence—a type of compensation. 

Employees often don’t have to worry about paying income taxes on their vested RSUs—companies do it on their behalf. This isn’t always the case—employees might be responsible for reporting this themselves.

Another way vested RSUs are taxed is through the capital gains tax. The amount depends on the duration the stock is held and how big the gain or loss is, but capital gains tax becomes relevant as soon as the shares are sold.

We report capital gains with Form 1040, schedule D to be more precise. In a way, vested RSUs are taxed double, but the tax hit can be minimized by having a strategy for when to sell.

Withholding RSU Taxes 👔

As mentioned, taxes aren’t paid until the RSUs vest and the employee gets the actual shares. When this happens, ordinary income tax and any applicable state income tax have to be paid over the total value of shares received. 

Companies often withhold RSUs to pay income taxes in place of the employee—visible on the W2 form. They usually sell up to 22% of the shares, which is the legal requirement—after which the employee receives the rest of the shares. 

If this doesn’t cover all the taxes or if the company chooses not to withhold tax at all, the employee has to—most likely—pay the taxes individually. For example, by selling all shares and using the money to pay taxes or selling only part of the shares to cover the taxes.

Another option is to hold on to the shares and use cash to pay the taxes. This method is especially good for employees who believe the value of the shares will grow—significantly—in the future.

What about Non-U.S. Employees? 🌍

For employees who live outside the U.S., the process is very similar. The taxes still have to be paid after vesting and the amount is based on the total value of the shares when the employee receives them. 

Non-U.S. employees also have to keep in mind capital gains tax after they sell the shares. However, knowledge of local tax treatment is advised, as the specifics might vary by country.

RSUs or Stock Options, What’s the Better Choice? 🏆

We’ve mentioned stock options briefly and explained that over time RSUs have become a very popular alternative—stock options are, however, still a very common way to compensate employees. 

A Promise vs. a Right 💭

So, why do employers choose one over the other? To find out, we need to understand the differences between the two. The biggest difference is that RSUs are a promise to deliver shares, whereas stock options give employees a right to buy shares.

The price they will be able to buy the shares at is predetermined and happens at specific dates in the future—often according to a vesting schedule. Whereas employees have to buy the stock when they exercise stock options, vested RSUs are shares given to the employee.

Tax Differences 📁

Both were designed for different purposes—explaining why they are taxed differently. RSUs are taxed right after vesting, but stock options aren’t taxed until exercised. 

Even after the right to buy is used, taxes don’t always have to be an immediate concern. If the options haven’t gone up in value and an 83(b) election is filed, the employee will pay taxes when the options are sold. 

Keep in mind that the company still has to withhold taxes—when the right to buy is exercised. Better safe than sorry—we don’t want the IRS to come after you, after all 💀.

Company Life Cycle 🔄

So, both have ups and downs—the decision often comes down to where a company is in the business life cycle. Since RSUs are taxed when they vest, a company needs to have enough cash to pay the taxes.

To have enough cash reserves, a company needs to have a solid income stream. This is often the case with mature, well-established companies—not so much with start-ups. 

Whereas shareholders of mature companies are often satisfied with an average market return, start-ups can potentially realize huge growth in a short period.

That’s why stock options often make more sense for—quickly growing—start-ups. 

With stock options, employees can potentially buy the stock way cheaper than the fair market value at the time of exercise.  The fair market value of mature company stock is often already quite high—making RSUs a more attractive option than stock options. 

RSUs: An Example 🏢

Let’s say Bob makes a great impression at a job interview and he ticks all the boxes. The company decides to offer him the job and they’re convinced he’ll be a valuable asset for the company for years to come. 

Especially given the labor shortage in the aftermath of the Covid-19 pandemic, the company offers Bob 4.000 RSUs in addition to the rest of his compensation package. Since the company’s share price is $2, Bob could potentially receive $8.000.

To motivate Bob to stick around, the shares will be awarded to him based on a four-year vesting schedule. He will receive the first 1.000 shares when he has been with the company for a year—the vesting cliff.

A further 1.000 shares will be awarded to him every year that follows until the vesting period ends and he has all 4.000 shares. The value of the shares Bob receives depends on how his company’s stock has performed over the years.

Final Words 📌

Restricted stock units are a perfect example of financial jargon most people never hear about until they’re confronted with it. Nevertheless, RSUs can greatly impact your financial situation and you’ve done yourself a tremendous favor by educating yourself on the topic.

You’ve learned what RSUs are, how they came about, how they work, and what the advantages and limitations are. We’ve given you a few selling strategies, discussed paying taxes, and stacked them up against stock options. As with any financial product, understanding what you’re dealing with is half the battle. 📚

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