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.
Advantages of stock options
– Offers employees an opportunity to have ownership in the company that they work for, which can lead to increased motivation, productivity, and loyalty.
– If the business is successful, then employees can potentially make a lot more money than just their salary.
– They offer some tax benefits.
Disadvantages of stock options
– They can be risky and employees could potentially not make any money.
– If employees don’t make any additional money then they may feel less satisfied.
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.
Advantages of RSUs
– Both the employer and employee will want to see the company succeed.
– It motivates the employee to work harder because they will see extra compensation for their work.
Disadvantages of RSUs
– RSUs are taxed at your federal and state income tax brackets.
– If the employee terminates then they will lose all of their unvested shares.
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.
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.
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.
Are stock options or RSUs better?
There are advantages and disadvantages to both stock options and RSUs. Stock options are generally better if the company is in its early stages and RSUs are generally better for a later stage company.
Although stock options can be a great perk, make sure that they aren’t your only financial plan. If something happens to the company then you could lose your entire investment. RSUs provide protection that doesn’t exist with stock options so you may want to think about how much risk you are willing to take. When deciding between stock options vs RSUs, or choosing both, the choice will vary from person to person.
Below are two hypothetical client scenarios to illustrate when stock options or RSUs may be the best option.
David is 58 and is getting ready to retire next year. David can choose between stock options and RSUs at the company he works for. If he retires with unvested RSUs then he will lose them. This means that he can collect the RSUs that vest in year one, but he will lose all of the additional shares in years two, three and beyond. While stock options come with greater risk, they may be a better option for David.
Olivia is 35 and recently completed a bathroom remodel. She took out a $80,000 line of credit to finance the project. She has very little in savings and is relying on her annual bonus to pay this off. RSUs may be a better choice for Olivia because they offer a more planned and predictable source of income which will allow her to pay off her debt.
|Stock Options||Restricted Stock Units (RSUs)|
|Grant Date||Dated on issuance ||Dated on issuance |
|Term||Expires 10 years from the grant date ||No expiration |
|Exercise Price||Set based on market value||No exercise price|
|Vesting||Can be vested anytime for any milestone||Can be vested anytime for any milestone|
|Payment||Stock||Stock or cash|
|Taxation||NSOs are treated as regular income. ISOs are treated as preferred items for alternative minimum tax||Taxed on vesting and treated as regular income (capital gains if stock is held for more than a year).|
|Taxation Timing||Option income is taxable at exercise ||RSU income is taxable at vesting |
|Dividends||Not entitled to receive dividends ||Usually none while unvested |
|Shareholder Rights||Full rights only upon exercise||None while unvested|
Stock options and RSUs are an important part of your overall compensation package.
Knowing how stock options and RSUs work and understanding the differences between them can help you make an informed decision about which may be best for you. If you need help figuring out your RSUs or stock option compensation, schedule a free discovery call with one of our fee-only financial planners today.
Alvin Carlos, CFP®, CFA is an investment advisor and fee-only financial planner, in Washington, D.C that works with clients across the country. He has a Master’s degree in International Relations from SAIS-Johns Hopkins. Alvin is a partner of District Capital, a financial planning firm designed to help professionals in their 30s and 40s achieve their financial goals through smart investing, reducing taxes, retirement planning, and maximizing their money. Schedule a free discovery call to learn how we can help elevate your finances.