How Do Restricted Stock Units Work?

What Is a Restricted Stock Unit?

A restricted stock unit (RSU) is a form of stock-based compensation used to reward employees. Restricted stock units will vest at some point in the future and, unlike stock options, will have some value upon vesting unless the company's stock becomes worthless.

RSUs can be an important part of your clients' compensation packages because they can help them build significant wealth. As a financial advisor, you can assist a client in getting the most out of this portion of their compensation.

How Restricted Stock Units Work

Restricted stock units represent the promise of a gift shares of a company's stock. They are usually granted to employees as a form of compensation. RSUs are controlled by a vesting schedule that determines when units placed in an employee's account become actual shares. Vesting schedules are usually based on length of employment or on performance milestones.

These stocks may also be restricted by a company in other ways. For instance, there may be specific limits on transfers or sales.

RSUs have no actual financial value to the employee when issued. However, once they vest, employees can receive shares of stock or, less commonly, an equivalent value in cash.

Until the RSUs vest, they remain an unfunded promise to compensate the recipient at some point in the future. Holders of RSUs have no voting rights, nor do they receive any dividends, but some companies may elect to pay dividend equivalents. For example, they may let dividends accrue and allocate those funds to cover some of the taxes due at vesting.

Vesting usually halts if the employee is terminated. However, in the event of employee death, disability, or retirement, vesting may continue. The actual plan and grant agreement control this.

Managing RSUs

Should a client retain the shares or sell some or all of them? Like most such questions, the answer depends on each client's situation.

Once RSUs vest, an employee receives company stock. Your client should take into account all other shares of company stock they hold in taxable and retirement accounts. If the employer's stock is a steady performer, a client may be tempted to hold the stock—after all, there was no cost to obtain the shares.

The decision to hold the shares upon vesting depends on the client's outlook on the company, the market, and their financial circumstances. If the shares have already appreciated, a client may feel that there's still upward price action to come. Or, they may decide that selling some or all shares is more financially worthwhile.

RSUs and Diversification

Many financial advisors caution against holding more than 10% of a portfolio in company stock.

Any concentrated stock holding is risky, but when it's an employee's company stock, they could run a two-fold risk if the company falls on hard times. For instance, losing one's job in a downturn and holding stock that's lost a great deal of value could mean a stiff financial hit.

It may be wise to caution clients to think of RSUs as cash bonuses. They could then decide whether to hold the stock or sell it and invest the proceeds elsewhere for diversification.

Death or Disability

Many company plans differ on what happens to RSUs in the case of death or disability, so it's important not to assume that the same treatment of other benefits and compensation applies to them. Consider recommending that a client find out specifically how this works from their company's benefits department.

RSUs and Vesting

Restricted share units typically use a graded or cliff vesting schedule. The schedule establishes an amount of time that must pass before shares are distributed and can be sold. Additionally, specific financial milestones may need to be met before employees can sell their shares.

Graded Vesting

A graded vesting schedule increases shares incrementally. For example, imagine an employee receives 10,000 RSUs with a four-year vesting schedule. Each year, on the anniversary date of the grant, one-quarter of the total RSU amount vests (2,500 shares). Typically, once each amount vests, the employee is allowed to sell the shares.

Depending on the company plan, a graded vesting schedule's distribution intervals can vary. So, with the example above, the employee could receive 2,500 shares on the first anniversary date. However, subsequent vesting of the remaining 7,500 shares might occur more quickly. For example, 625 shares might be vested monthly during the following year.

Cliff Vesting

The alternative to graded vesting is cliff vesting. Cliff vesting involves vesting the total amount of a grant once an employee has worked for a company for a specific period, such as two or four years.

Alternatively, cliff vesting might involve performance milestones for an employee or company (such as reaching a certain stock market price).

RSUs and Taxes

Employees are taxed when RSUs vest and shares are distributed. The value of the shares is determined by the market price on the day of vesting/distribution. Since this is compensation income, the company will withhold the taxes from the employee's wages.

The withholding will include federal income tax, state and local taxes, if applicable, and taxes for Social Security and Medicare.

Employees who keep their shares and subsequently receive dividend payments must pay ordinary income tax on the dividend amounts.

If employees hold and then sell shares that have appreciated, they'll owe capital gains tax on the difference between the sale price and the value of the shares upon vesting. The actual tax rate will be determined by whether there are long-term capital gains or short-term capital gains.

Some companies may have arrangements to handle taxes owed by employees at vesting. The typical approach is to have the employee surrender enough of the distributed stock back to the company to cover the taxes. The company then uses its cash to pay the payroll tax.

If a client is poised to become vested in a significant amount of shares in a given year, you can help them focus on minimizing the tax impact. For instance, it might be wise to lump deductions from prior or future years into the year of vesting.

RSUs vs. Stock Options

Stock options represent a right to buy (or sell) shares of stock at a particular price (the exercise price) by some future date. One stock option contract generally represents 100 shares of stock. A new company may grant stock options to employees to motivate them to stay and help build the organization.

In fact, stock options presented as compensation by a company that's already public usually have a vesting schedule. Just like for RSUs, this stops people from leaving after only a short time with shares of company stock that may be valuable.

Unlike RSUs, stock options don't involve a transfer of ownership. Employees who receive stock options must buy the underlying shares themselves at the exercise price. Often, they profit by then selling their shares at a higher market price.

Other Considerations

What happens if your client receives a job offer from a competitor before the vesting of some or all of the RSUs granted? You can help that client place a value on the RSUs, which would be lost. That value could be used as part of the compensation negotiation between the client and the potential employer. 

If there are significant unvested portions of RSUs, it may also behoove your client to stay with the current employer until they are vested.

At retirement, any vested RSUs belong to the employee. If they stand to lose RSUs with significant value, again, it may pay to continue working until the RSUs vest.

If your client’s employment with the company is terminated involuntarily, in all likelihood, any unvested RSUs will be forfeited.

The firm should have an employment agreement or RSU plan rules that address the treatment of RSUs in these and other circumstances. Once again, be sure to advise your clients to become familiar with such rules.

The Bottom Line

RSUs can be a high-value component of a client’s overall compensation package and wealth-building strategy. A financial advisor can provide valuable advice and planning assistance to clients who want to capitalize on the financial benefits offered by RSUs.

Consider emphasizing to your clients the importance of understanding how RSUs work and the role they may play in the compensation they receive over time.