If you feel like learning about personal finance is akin to learning a foreign language, you’re not wrong. The amount of jargon and acronyms can make finance topics seem much more complicated than they really are. Fortunately, acronyms like RSUs (restricted stock units) are relatively simple to understand once you get past the intimidation factor.
What is an RSU?
RSU stands for restricted stock unit. If you haven’t heard of these before, you’re not alone. However, just because you haven’t heard of them or don’t currently own them, doesn’t mean you should disregard what they are and what they could mean for you.
In a nutshell, RSUs are employer issued stocks that are given to employees, typically executives, as a part of their compensation plan. While other stock options used to be the tool of choice for employers to attract and retain valuable employees, RSUs have been on the rise since the mid 2000’s. What used to be primarily a tech industry offering has now expanded to many large companies across a variety of industries. Examples include Aflac, GoDaddy, The Cheesecake Factory, Intuit, Nordstrom, and Whole Foods Market, to name a few.
How do RSUs differ from regular stocks?
One of the primary differences between ordinary shares of a company and restricted stock units are the way in which they are issued. RSUs are issued to employees as a part of a vesting plan. If you aren’t familiar with what vesting means, it is a metered approach that many companies use to divvy out benefits over a span of time – hence why RSUs can be used as a retention tactic.
What does vesting mean?
Vesting can apply to more than just stocks. For example, some companies require a vesting period for their employer-matched contributions to a retirement plan. Common vesting periods range from 3-5 years. Additionally, the vesting schedule can vary.
One option is done by vesting employees by a certain percentage per year. For example, you could be vested at 20% per year over the course of 5 years. Another option is to vest an employee all at once upon completion of the vesting period. E.g., you could be fully vested (100%) at the end of a 3 year vesting period.
What happens once RSU stocks are vested?
Prior to being vested, RSU stocks have no real value to the employee. Think of them as a promise at this stage. Upon vesting that promise is fulfilled, as long as the company is still positively valued. Once vested, RSUs acquire the current market value and are then considered the same as any other share of the company’s stock (i.e. no longer restricted).
Because RSUs become valuable at the point of vesting, employees are typically required to report the entire value of those shares as ordinary income for tax purposes. There are few instances where employees may be able to defer taxation at that stage, but it is important to ask your employer what your options are. Depending on the value of your shares and how many you were issued, your taxable income could be drastically higher the year you’re vested. Your best bet will be to proactively plan this out with your employer and a tax professional.
What can you do with your RSUs once they are vested?
Remember, once vested, RSUs are the same as any other ordinary share of the company’s stock. At the point of vesting, you can opt to either sell or keep your shares. Restricted Stock Units are a selling point to employees as a part of their compensation plan. It helps employers to attract and retain valuable employees. And upon vesting, if employees opt to keep the shares, it acts as an additional incentive to keep up the good work. Because, if the employees do well, the company does well, the stock price rises, and round and round goes the carousel.
You may choose to retain the stock because you believe it will increase in value. However long you choose to keep it, you’re free to sell any or all of it at a later date of your choosing. Just remember to keep in mind your total investment portfolio diversification. Having a properly diversified portfolio is one of the best ways to mitigate investment risk. It is typically not advised to hold more than 10-15% of your portfolio in your employer’s stock.
If you instead opt to sell your shares, keep in mind that you will pay a capital gains tax.
Advantages of RSUs
Restricted Stock Units provide benefits to both employers and employees. For employers, it provides a means to attract and retain valuable employees. For employees, it is an avenue for additional compensation. It also enhances the value connection between employee and employer. When the company does well, the employee does well, and vice versa.
Disadvantages of RSUs
While RSUs are considered part of your total compensation, they do not technically provide any tangible value until they’re vested. If an employee leaves before those shares are vested, they will likely forfeit them.
The vesting period is an important consideration when you take into account the time value of money concept. Money now is worth more than the same sum of money later on because of its earning potential. For example, consider if you were paid out a $10,000 cash bonus immediately upon hire instead of a promise of RSU shares that would be vested in 3 years. You could easily invest that $10,000 in the S&P 500 and expect your returns to average 7% annually, adjusted for inflation.
Questions to ask your employer if they offer RSUs
While we’ve gone over the important highlights and structure of RSUs, it’s important to note that individual companies may have other strings and contingencies to be aware of. If your are currently in possession of RSUs, or are considering accepting a job that will offer them, it’s important to ask the following questions:
- What happens in the event of termination, death, or retirement?
- How will taxes be withheld?
- What will happen to RSUs if the company is restructured or sold?
The bottom line
RSUs are a compensation benefit realized after a designated vesting period. As with any type benefit acquired through a vesting period, it’s important to keep the right perspective when deciding what makes sense for your individual situation. Beyond deciding whether or not to sell your shares once vested, another common consideration from people who are mid-vesting period is to try to determine whether or not it makes sense to stick it out or move on to another job.
According to a 2020 Bureau of Labor Statistics study, the median length of time the average US worker stays with an employer is 4.1 years. Recall that the average vesting period is 3-5 years. However, there are tangible benefits to employees who move careers as quickly as every 2 years. Because the average employee is able to acquire a raise between 10-20% for each job change, that can result in an increase of up to 50% greater earning potential over the lifespan of an employee who changes jobs every 2 years compared to an employee who changes jobs less frequently. That’s a tremendous difference.
Regardless of what you choose, remember to consider the time value of money and weigh your options with a cost benefit analysis. What is the benefit to staying in your current job until you’re vested? What is the cost of staying? Do your best to think through these costs and benefits objectively and choose the path with the greatest advantage.