Understanding RSU Vesting and Its Tax Implication

For those working at companies that offer restricted stock units (RSU) as part of their compensation package, it will be a regularly occurrence for you to make the decision to sell your RSU or not when they vest. While this may seem like a trivial binary choice, it's important to understand how RSU vesting exactly works so you can make a more informed decision, especially when it comes to selling RSUs to cover taxes owed.

What Are RSUs?

Restricted Stock Units (RSUs) are company shares granted to employees as part of their compensation package, which vest over time. RSUs will typically be included as part of the initial offer and then refreshed/updated as part of an annual review, a promotion, or if the company decides to extend a retention offer. Not all companies offer RSUs, but this is common for large publicly traded companies. The business strategy of RSUs is, in theory, is to encourage employees' long-term commitment and performance to the company. It's like a carrot on a stick...

The Vesting Process

The vesting process for RSUs begins with the grant date, when the company awards RSUs to the employee. However, these shares do not belong to the employee until vest (not to be confused with Restricted Stock Awards (RSAs) which actually belong the the employee at grant). Thus, RSUs cannot be sold or transferred until they vest according to a predetermined schedule, which is often based on tenure or specific performance milestones. For example, an employee might receive 100 RSUs from their initial offer that vest over four years, with 25 shares vesting each year.

Taxation at Vesting

When RSUs vest, their fair market value (FMV) on the vesting date is considered ordinary income. The FMV is the current market price of the shares on the date they vest. Consequently, this amount is subject to income tax. Employers usually handle this tax liability by allowing employees to elect to withhold a portion of the shares to cover the taxes, a method known as "sell to cover" or "net settlement." For instance, if 100 RSUs vest at $50 per share, resulting in $5,000 of taxable income, an employee might elect to withhold 30 shares to cover the tax bill, leaving the employee with 70 shares.

It is important to note that the cost basis for the vested shares is established based on their FMV at the time of vesting. This cost basis is essential for calculating future capital gains or losses if the shares are sold. For example, if the FMV at vesting is $50 per share, this value becomes the cost basis. The holding period for capital gains tax purposes starts on the vesting date. If the employee later sells the shares, the difference between the sale price and the cost basis determines the capital gain or loss, which is taxed accordingly.

Should You Sell to Cover?

I decided to write this post because I often get asked whether it's better to sell old RSUs that have reached long-term status (> 1 year hold) or sell the newly vested stock to pay for the ordinary income tax due. In my opinion (and I'm not a financial advisor 😅), it makes more sense to sell the newly vested stock because there is no capital gains tax to optimize at vest. Typically, the new capital gains for electing to sell at vest is near or at zero (e.g. if FMV is $50, then it'll be bought and sold at ~$50, making it a new capital gains of ~$0) making the difference between your ordinary income tax bracket and the tax efficient long term capital gains rate not impactful on the savings.