October,20 2024
How RSUs Work: A Complete Guide to Avoiding Costly Mistakes

Restricted Stock Units (RSUs) are a popular form of equity compensation many companies use to incentivize employees. Still, they can also present challenges if you’re unfamiliar with their work. In this guide, we will explore what RSUs are, how they function, their tax implications, and strategies for managing them. Whether new to RSUs or looking to fine-tune your plan, this article will help you avoid costly mistakes.
What Are RSUs?
RSUs, or Restricted Stock Units, are a form of equity compensation where an employer grants you company stock, but the shares vest over a set period. Typically, they come with restrictions, meaning they don’t become yours until you meet certain conditions, such as staying with the company for several years or hitting performance targets.
For example, let’s say you’re granted $100,000 in RSUs that vest over four years. In this scenario, 25% of your RSUs (or $25,000 worth of stock) would vest yearly, becoming available to sell, hold, or manage as you see fit. However, until the shares vest, they are essentially worthless to you. If you leave the company before they vest, they’re forfeited.
Companies often use RSUs to retain top talent, incentivize employees to stay longer and align their interests with the company’s performance.
How Are RSUs Taxed?
One of the most important things to understand about RSUs is how they are taxed. While you don’t owe taxes when granted the RSUs, you will owe taxes once the shares vest. At the time of vesting, the value of the RSUs counts as ordinary income so that it will be taxed just like your salary or a bonus.
Let’s use an example to clarify. Suppose you work at Microsoft and have $100,000 in RSUs that vest over four years. After one year, 25% (or $25,000 worth) of the RSUs vest. At the time of vesting, Microsoft’s stock has increased by 20%, making that portion worth $30,000. When the shares vest, you owe taxes on the $30,000 as ordinary income.
Here’s what’s essential: RSUs are taxed at ordinary income rates, not at the lower long-term capital gains rates. If you hold the vested shares and the stock appreciates, any additional gains will be taxed at either long-term or short-term capital gains rates, depending on how long you hold the shares after vesting.
Managing Your RSUs: A Real-World Example
Now that you understand how RSUs work let’s discuss strategies for managing them effectively. One of the most important decisions you’ll face is whether to keep your vested RSUs in company stock or sell them and diversify your portfolio.
Step 1: Think of RSUs as a Cash Bonus
The first step in managing RSUs is changing your thoughts about them. Imagine you received a $30,000 cash bonus (the value of the vested stock). Would you invest all that cash back into your company’s stock or diversify it across different investments? If your answer is anything other than reinvesting it all in company stock, selling some or all of the vested RSUs is probably best.
By selling, you can diversify your holdings, reduce risk, and avoid having too much of your portfolio tied to one company’s performance. Just because your company’s stock has performed well recently doesn’t guarantee it will continue to do so.
Step 2: Avoid the Mistake of Chasing Performance
Many employees make the mistake of holding onto their RSUs, believing their company’s stock will continue to outperform the market. However, past performance does not predict future results, and holding onto too much company stock can expose you to unnecessary risk.
For example, Tesla stock surged over 700% in 2020, but in 2022, it lost nearly 65% of its value—employees who held onto their vested RSUs without diversifying suffered significant losses. A more prudent strategy is to sell some of your vested shares and reinvest them in a diversified portfolio.
Tax Implications to Consider
When your RSUs vest, you will owe taxes on the value of the shares at ordinary income tax rates. The most common methods for handling taxes on RSUs are:
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Sell to Cover:
In this scenario, the company sells enough shares to cover your tax liability. For example, if 25% of your RSUs vest and are worth $30,000, and your tax rate is 33%, the company would sell $9,900 worth of stock to cover taxes, leaving you with $20,100 in shares.
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Same-Day Sale:
You can sell all your shares immediately upon vesting. This option is ideal if you want to avoid having too much exposure to your company’s stock and prefer to reinvest the proceeds in a diversified portfolio.
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Cash Payment:
If you choose not to sell shares, you can pay the taxes out of pocket, which lets you keep all your shares, but you must ensure enough cash to cover the tax bill.
Important Considerations: Default Withholding Rates
When your RSUs vest, your company will automatically withhold a portion of the shares to cover federal taxes, often at a rate of 22%; however, if you’re in a higher tax bracket, such as 35%, this could leave you with a significant tax shortfall when you file your taxes. Make sure you understand your marginal tax bracket and plan accordingly.
Beware of the Wash Sale Rule
If you sell shares to take advantage of tax loss harvesting, be mindful of the wash sale rule. If you sell a stock at a loss and acquire substantially identical stock within 30 days before or after the sale, the IRS will disallow the loss. The day your RSUs vest is considered a “purchase” for wash sale purposes, so be cautious if you’re doing tax loss harvesting in other accounts.
Key Takeaways
- RSUs are taxed at ordinary income rates when they vest.
- Diversifying your holdings is often a smart strategy to reduce risk.
- Consider tax planning, especially regarding withholding rates and wash sale rules.
If you manage RSUs as part of your compensation package, it’s crucial to consider them part of your overall financial strategy. Treat vested RSUs like cash bonuses and plan accordingly to minimize risk, optimize tax efficiency, and align with your long-term financial goals.
Disclaimer:
We believe the information in this article is accurate, but we do not guarantee it. Consult a financial advisor before deciding on equity compensation or tax planning strategies.