How Are Restricted Stock Units (RSUs) Taxed?

Restricted Stock Units (RSUs) are a common form of equity compensation, granting employees shares that vest over time. In the U.S., RSUs are taxed as ordinary income when they vest, based on their fair market value at that time. This triggers federal, state, and payroll taxes and any subsequent gains or losses are taxed as capital gains when the shares are sold. Understanding the timing and tax implications of RSUs is crucial for effective financial planning.

A financial advisor can walk you through different RSU requirements, including vesting, taxes and other costs.

How Restricted Stock Units (RSUs) Work

RSUs are a form of compensation that companies use to incentivize employees. The process begins when a company grants RSUs to an employee. At this stage, the employee does not own the actual shares but rather has the right to receive them in the future.

RSUs are often subject to a vesting period, which specifies the conditions that must be met for the RSUs to “vest” or become fully owned by the employee. Vesting conditions can include:

Time-based vesting: RSUs vest over a specified period, such as three years. For example, an RSU grant might vest 33% each year over three years.
Performance-based vesting: RSUs may vest based on the achievement of specific performance goals, such as hitting revenue targets or increasing the company’s stock price.
Milestone-based vesting: Vesting may occur upon the completion of certain corporate events, such as an acquisition or IPO.

Once the RSUs have vested according to the established conditions, they convert into actual shares of company stock. At this point, the employee becomes a shareholder and has the rights and privileges associated with stock ownership, such as voting rights and the potential for dividend payments.

How Are RSUs Taxed?

Restricted Stock Units (RSUs) are taxed at two key points: when they vest and when they are sold. At vesting, the fair market value of the vested shares is treated as ordinary income and is subject to federal, state and payroll taxes, just like a cash bonus. This amount is typically included in an employee’s W-2 and is taxed at their ordinary income tax rate. Employers often withhold a portion of the shares to cover tax obligations, but employees may still owe additional taxes depending on their overall income.

When RSU shares are later sold, any gain or loss is subject to capital gains tax. If the shares are sold immediately after vesting, there may be little to no capital gain. However, if they are held for more than a year, any appreciation is taxed at the lower long-term capital gains rate. Understanding these tax implications is crucial for managing RSUs effectively and avoiding unexpected tax liabilities.

RSUs vs. Stock Options

SmartAsset: How Are Restricted Stock Units (RSUs) Taxed?

Employees usually face a choice between two types of equity compensation: RSUs and stock options. Here are five common areas in which both types of assets differ:

1. Grant and Ownership:

RSUs: RSUs represent a promise from the employer to give employees a specific number of company shares once certain vesting conditions are met. When RSUs vest, employees receive actual shares of company stock and become shareholders.
Stock Options: Stock options grant employees the right to purchase a specified number of company shares at a predetermined price, known as the exercise price or strike price. Employees do not own the shares outright; instead, they have the option to buy them at a later date.

2. Vesting:

RSUs: RSUs are often subject to vesting schedules, typically based on time or performance conditions. Once the RSUs vest, employees receive the shares as part of their compensation.
Stock options: Stock options may also be subject to vesting, but the vesting typically applies to the right to exercise the options rather than ownership of the shares themselves. Once options vest, employees can choose to exercise them, purchasing the underlying shares at the predetermined price.

3. Taxation:

RSUs: RSUs are generally taxed as ordinary income at the time of vesting based on the fair market value of the shares on that date. Employees are responsible for paying income tax (and employment taxes) on the value of the vested RSUs. Any subsequent capital gains from selling the shares are taxed as capital gains.
Stock options: Taxation is quite complicated and depends on the type of options granted and timing. Incentive stock options (ISOs) do not tax employees upon exercise, but they may face an alternative minimum tax (AMT). Non-qualified stock options (NQSOs), on the other hand, are taxed as ordinary income when exercised. This is based on the difference between the fair market value of the shares and the exercise price (the spread).

4. Risk and Reward:

RSUs: RSUs have no upfront cost (other than taxes) for employees, but they are subject to market risk. If the share value declines after vesting, employees suffer capital losses.
Stock options: Stock options give employees the potential for significant gains if the stock price rises above the exercise price. However, employees must pay to exercise the options and may incur a financial loss if the stock price falls below the exercise price.

5. Dilution:

RSUs: RSUs can lead to dilution of existing shareholders when they vest and result in the issuance of new shares.
Stock options: Stock options do not result in dilution until they are exercised. When options are exercised, new shares are issued.

It’s important to talk to a financial advisor about how either of these opportunities might fit into your long-term financial planning.

How to Report RSUs on Your Taxes

Reporting Restricted Stock Units (RSUs) on your taxes requires understanding how they are taxed and where to report them on your tax return. Here’s a general overview on how to report RSUs on your taxes:

Gather relevant documents: Collect all necessary documents related to your RSUs, including your Form W-2 (if applicable), Form 1099-B and any statements or documents provided by your employer or brokerage.
Determine your vesting date: Identify the vesting date or dates when your RSUs became fully owned by you. This is the date when the value of the RSUs is considered taxable income.
Calculate your taxable income: Determine the fair market value of the vested RSUs on the vesting date(s). This value is typically reported on your Form W-2 if the RSUs are granted by your employer. If not, you may need to obtain this information from your employer or brokerage.
Report on Form 1040: Report the income from your RSUs on your annual federal income tax return, specifically on Form 1040. Use the income reported on your Form W-2 or other relevant tax documents. If the income is not reported on a W-2, report it on the appropriate line for “Other Income” on your tax return. (A note for contractors or non-employees: You will see the RSU included in your 1099-NEC income. Report it as you would with any other similar income.)
Include state taxes: If your state imposes income taxes, report your RSU income on your state tax return as well. The reporting process may vary depending on your state’s tax laws.
Review withholding and estimated payments: Check your withholding status and the amount of taxes withheld by your employer or brokerage when the RSUs are vested. Make sure that the withholding is sufficient to cover the tax liability associated with your RSUs. If not, you may need to make estimated tax payments to avoid penalties.
Consider deductions and credits: Explore potential deductions and tax credits that may be available to you. Some deductions or credits may offset the tax liability associated with your RSUs.

Note: Taxes can get complicated. So it may be to your benefit to contact a tax professional.

Bottom Line

RSUs have become a popular form of equity compensation, especially in the technology and startup industries. They offer employees a stake in the company’s success and align their interests with the company’s performance. However, employees need to understand the terms of their RSU grants, including vesting schedules and taxation, to make informed decisions about their stock compensation.

Tax Tips for Employees

If you have complex RSU transactions, multiple grants or are unsure about how to report RSUs on your taxes, consult a financial advisor. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Vesting doesn’t give an employee unrestricted access to benefits. For example, employees age 59.5 who withdraw from 401(k) plans may owe penalties on those distributions. And they may have to wait several months after an initial public offering to sell even fully vested shares and stock options.