When considering your overall compensation, you should pay attention to what’s beyond your paycheck. Stock options and restricted stock units (RSUs) are both super common ways that employers compensate their employees with equity, but companies don’t always do the best job of educating folks on what their holdings are actually worth. The first step towards understanding the value of your equity is simply understanding the ins and outs of what these holdings are and how they work. So, let’s break it down.
RSUs and stock options are both forms of employee equity compensation — or non-cash compensation — offered to an employee by an employer. RSUs and options are generally the most common forms of equity compensation, but they are very different and you will want to approach them with different strategies to maximize your net worth. So, what exactly is the difference between stock options vs. RSUs?
Stock Options vs. RSUs: What’s the Difference?
Stock options are probably the most well-known form of equity compensation. A stock option is the right to buy a specific number of shares of company stock at a pre-set price, known as the “exercise” or “strike price,” for a fixed period of time, usually following a predetermined waiting period, called the “vesting period.” Most vesting periods span three to five years, with a certain percentage of options vesting each year (which means you’ve “earned” your shares), though you still need to exercise (i.e., purchase them).
With stock options, if you wait to hit certain milestones, your tax treatment may be better. You could receive favorable tax treatment if you wait for two years from grant date and one year from date of exercise to sell your shares. Once these two milestones are met, any profit you generate from the sale of your stock will be taxed as long-term capital gains. (Note: This holding period is only applicable to ISOs, and you could be subject to taxation when you exercise the share.)
Keep in mind that these are very high-level guidelines; since every situation is unique, you should check with a professional to see if these apply to you.
RSUs are a type of restricted stock (which may also be known as “letter stock” or “restricted securities”). Restricted stock is company stock that cannot be fully transferable until certain restrictions have been met.
These can be performance or timing restrictions, similar to restrictions for options. You can think of restricted stock as a bonus awarded as stock instead of cash; however, like cash, it is taxed as if it was paid in cash (i.e., as ordinary income).
Restricted stock can be a popular alternative to stock options, particularly for executives, due to their favorable accounting rules and income tax treatment. There are two basic types of restricted stock: Restricted Stock Awards (RSAs) and Restricted Stock Units (RSUs).
Restricted Stock Units can be awarded on regular vesting schedules or performance benchmarks, which means that the value of the RSUs on the day of vesting is subject to payroll and ordinary income taxation.
The key difference is that RSUs are issued in the form of units – not stock – that correspond in number and value to a specified number of shares of employer stock. Upon vesting, you’ll get your equivalent shares.
With stock options, the incentive is the possibility of owning stock of the company at a discounted rate compared to buying the stock on the open market.
Stock Options vs. RSUs: Which is Better?
There are benefits and drawbacks to both stock options and RSUs. Deciding which one is better will depend on your individual circumstances and other factors, including taxation. RSUs are taxed at ordinary income tax rates as soon as they become vested and liquid. Employers usually withhold some of the RSU to pay taxes, just like they withhold a portion of salary and wages to pay income taxes, though you might be given the option to pay taxes with cash on hand so you can retain all of your vested RSUs.
In contrast, stock options aren’t taxed until they are exercised. If you hold onto stock options for at least one year, they will be taxed at more favorable capital gains tax rates. Stock options usually aren’t exercised until after a company goes public when the employee can sell enough shares to cover the tax owed on the appreciation.
Another important thing to consider is the fact that stock options only have value if the price of the stock goes up in the future. If the stock price doesn’t rise, then you would be paying more for the shares than you could sell them for. The value of RSUs, on the other hand, isn’t contingent on the stock price rising in the future. They are simply awarded by the company when certain performance requirements are fulfilled or after you’ve worked at a company for a certain period of time.
This is one reason why RSUs tend to be less common than stock options. If given the choice, you should weigh the potential benefit of major price appreciation that could make stock options extremely valuable in the future against the risk that the stock price doesn’t appreciate at all and the options are worthless. In contrast, RSUs are relatively safe because their value doesn’t depend on stock price appreciation.
Stock options and RSUs are both popular forms of equity compensation and can ultimately result in a significant piece of your net worth. Therefore, it’s important to fully understand tax implications and how your equity might weigh your overall portfolio. Working with a financial advisor is a good way to help tease through these complexities.