RSUs and stock options are both forms of employee equity compensation offered to an employee by a company. When you are considering your compensation, you should look beyond your paycheck to see if you are offered RSUs or stock options. Some companies offer the choice of selecting between stock options or RSUs or a 50/50 mixture of both. Understanding the differences between stock options vs RSUs will help you make an informed decision about which equity compensation is best for you and adjust your financial plans accordingly.
What are stock options?
Stock options are the most well-known form of equity compensation. Stock options offer you the right to buy company stock at a certain price (the exercise price). However, there is no obligation to do so. It’s important to know when the options expire, which is usually 10 years. After the expiration date, you can no longer buy the company stock. You would only exercise the stock options if the exercise price is below the market price, otherwise it wouldn’t be worth it.
Employee stock options are more complicated than RSUs. You need to understand what type you have, and then plan which actions you should take from there. There are two types of stock options. These are non-qualified stock options and incentive stock options. NSOs are stock options that do not qualify for special tax treatment and ISOs are stock options that do qualify for special tax treatment.
What is an RSU?
Restricted Stock Units (RSUs) are a type of stock compensation that has strings attached to it. It is a commitment by the company to give the employee stocks in the company when pre-determined requirements are met. These requirements might include performance goals or staying with the company for a certain amount of time. RSUs don’t require you to make too many decisions around what to do with them.
What are the key differences between stock options and RSUs?
There are several differences between stock options and RSUs that are important to take into consideration. One is not necessarily better than the other, but be aware of the differences so you can make a decision on whether stock options or RSUs are best for you.
Taxes are one of the most important things to consider when you are deciding between stock options and RSUs.
RSUs and Taxes
When RSUs are first granted but still restricted, then no income tax is due. As soon as they vest, then it is counted as earned income and will be subject to income tax. The taxable income is equal to the market value of the shares at this time. Income tax can be as high as 48% (Federal and State) depending on the value of your RSUs and the state in which you live. It’s important to note that it’s not uncommon for an employee’s regular income plus the value of the RSUs to push them into a higher tax bracket. An exception to the above is filing an IRS 83(i) election to get a 5-year deferral. Ordinary income tax will still be due on the RSU value but additional increases in value will be subject to capital gains tax instead.
Stock Options and Taxes
Taxes for stock options are quite different. Options are not taxed until they are exercised. The ability to pick and choose when you want to exercise your stock options gives you additional flexibility for tax planning purposes. If you hold onto stock options for at least one year, they will be taxed at more favorable capital gains tax rates. Stock options are usually exercised after a company goes public. Once this happens then the employee can sell enough shares to cover the tax owed on the appreciation.
Non-qualified stock options (NSOs) and incentive stock options (ISOs) are taxed differently. For NSOs, you are taxed on the difference between the market price and the grant price upon exercise of the stock option. This is taxed as regular income so it’s subject to income tax and payroll taxes. For ISOs, no taxes are due upon exercise but the spread is subject to alternative minimum tax.
Stock options vs RSU risk
It is important to think about how the company might perform in the future. Stock options require an increase in a company’s stock price to have value and RSUs do not.
With stock options, if the stock price falls or stays the same as the price that the options were when they were granted, then the stock option is worth nothing. The higher the stock price is above the grant price, the greater your return will be. Stock options are a risker option than RSUs but they can deliver greater returns.
RSUs carry less risk than stock options. They will always have value as long as the company’s stock price is above $0. The value is fixed at the stock price at vesting.
If you have to choose, you’ll have to weigh the relative safety of RSUs with stock options’ greater risk and potential returns.
The vesting period is the amount of time before the RSUs or stock options are unconditionally owned by the employee. RSUs can vest every month, quarter or year and be over a period of many years. Stock options typically vest over three, four or five years.
There is a difference between what happens with stock options and RSUs once the vesting period is over. If you have stock options then once the vesting date arrives, you still have to decide whether to exercise the option to buy the company stock. When an RSU vests, the company stock is immediately owned by the employee.
Stock options and RSUs are an important part of your overall compensation package.