Stock Options vs. RSUs: What’s the Difference?

If you’re a key employee or executive, stock options and restricted stock units (RSUs) can be a valuable part of your income and overall financial plan.

Indeed, both offer the opportunity to share in your company’s success and potentially increase your net worth. Yet it’s essential to understand how stock options and RSUs differ, so you can make informed decisions regarding your equity compensation.

In this article, we’ll explore the key differences between stock options and RSUs, including their potential risks, tax implications, and other defining characteristics, so you can maximize your employee benefits while staying on track toward your financial goals.

Why Do Companies Award Stock Options and RSUs?

For employers, stock options and RSUs can be powerful tools to attract and retain talented employees. These types of equity compensation tend to incentivize long-term commitment and align the interests of the employees with those of the company.

At the same time, stock options and RSUs give employees the chance to boost their overall compensation by sharing in the success of their employer. However, the specific advantages and potential drawbacks depend on which type of equity compensation you have.

Generally, employees don’t get to choose which type of equity compensation they receive. Instead, employers usually decide whether to grant stock options or RSUs (or a mix of the two) based on a variety of factors, including their compensation strategy, stage of development, and tax implications.

For example, more established companies may grant RSUs more frequently since they’re less risky for the employee and the value is more predictable. Meanwhile, start-ups and early-stage companies may prefer to grant stock options, as the company can then defer the issuance of shares until their employees exercise their options.

Key Characteristics of Stock Options

Employees with stock options have the right (but not the obligation) to purchase a set number of company shares at a fixed price (the exercise or strike price) for a set period. Employers typically require employees to stay with the company for a certain amount of time before their options vest so they can exercise them.

Ideally, stock options give employees the opportunity to buy shares at a discount, resulting in an immediate gain if the company performs well. Yet there’s also the risk that the company’s share price will fall below the exercise price, and the options expire worthless.

There are two types of stock options companies grant their employees: non-qualified stock options (NQSOs) and incentive stock options (ISOs). Typically, only executives and key employees receive ISOs as part of their compensation package.

Tax treatment depends on which type of stock options you hold. With NQSOs, the difference between the exercise price and the current stock price at the time of exercise is taxed as ordinary income. Then, any subsequent gain at the time of sale is subject to capital gains taxes. You must hold onto your shares for at least one year to pay the lower long-term capital gains rate.

With ISOs, you pay no taxes at the time of exercise, but the difference between the exercise price and the current stock price may be subject to the Alternative Minimum Tax (AMT). If you sell your shares at least two years after your grant date and at least one year after your exercise date, any gains will be taxed at the long-term capital gains rate. Otherwise, part of the gain may be subject to your ordinary income tax rate.

Key Characteristics of RSUs

RSUs are a promise from your company to grant you shares at a future date once certain vesting criteria or performance benchmarks are met. Each RSU corresponds to a specific number and value of company stock.

For example, suppose your agreement states that one RSU equals one share of company stock. If your company stock is currently worth $50 per share and your employer grants you 100 RSUs, your RSUs are worth $5,000.

Unlike stock options, RSUs have value at the time of vesting, regardless of the stock price at the time. Yet RSUs typically offer less upside potential than stock options since you don’t get to choose when to exercise them.

The tax implications of RSUs also differ from stock options. When your RSUs vest, the fair market value of your shares at the time of vesting is subject to ordinary income taxes.

When you sell your RSUs, any gain from the time they vest is considered a capital gain. If you hold your shares for at least one year, you’ll pay the long-term capital gains rate.

Common Misconceptions about Stock Options and RSUs

Despite their potential value, many employees with equity compensation fail to maximize their benefits due to a lack of education. According to one study, 48% of employees with equity compensation have never exercised their options or sold granted shares due to fear of making a mistake.

Thus, it’s important to understand the fundamentals of stock options and RSUs to avoid potentially costly mistakes. Here are three examples of common misconceptions employees have when it comes to their equity compensation:

• RSUs are always better because they have value regardless of the stock price. While it’s true that RSUs have value so long as the company’s stock price is above zero, stock options often provide greater potential upside if the company’s stock price rises significantly.
• Stock options are always riskier than RSUs. Indeed, stock options carry the risk of expiring worthless if the share price falls below the exercise price. However, the risk and reward profile of both types of equity compensation should be considered within the context of your overall financial situation, risk tolerance, and goals.
• Taxation of stock options and RSUs is straightforward. Taxation of equity compensation is a complex subject. There are numerous factors that can affect the amount of tax you owe, including the type of stock options, the timing of exercise and sale, and changes in tax laws. It’s crucial to consult with a tax advisor or financial planner with expertise in equity compensation.

Managing Your Stock Options and RSUs

There are several factors to consider when managing your stock options and/or RSUs. Examples include:

• Your short-term financial needs and long-term goals. Your financial plan can serve as a useful guide for managing your equity compensation. For example, if you’re planning for retirement, you might opt to hold onto vested shares for long-term growth. If you’re saving for a short-term goal like putting a down payment on a new home, you might consider selling your shares as they vest to create liquidity.
• Your vesting schedule. Both stock options and RSUs come with vesting schedules, which are the timelines that dictate when you can exercise options or when RSUs become yours outright. Understanding these timelines can help you plan for potential income and tax implications.
• Concentrating a significant portion of your wealth in your company’s stock can be risky—especially if your main source of income also depends on company performance. It’s important to consider how your stock options and RSUs fit into your overall investment strategy and whether you need to diversify into other assets.
• Tax Planning. The tax implications of stock options and RSUs are complex. It’s important to be proactive and consider strategies to minimize your tax liability. You may want to consider working with a financial planner or tax expert who fully understands the tax implications of equity compensation.

Like any aspect of your financial plan, it’s important to revisit your equity compensation approach as your financial circumstances, goals, and the external environment evolve.

SageMint Wealth Can Help You Navigate Your Equity Compensation

An experienced financial planner like SageMint Wealth can help you evaluate the potential value of your equity compensation versus the associated risks and tax consequences.  Our team understands the complexities of stock options and RSUs and can help you develop a plan for managing them that supports your financial goals.

SageMint Wealth is a Southern California-based wealth management firm for high-net-worth individuals, families, and business owners. We have a passion for supporting women, the LGBTQ+ community, and individuals in the technology space. Please contact us to see if we may be the right fit for your financial planning needs. We’d love to hear from you.