Are RSUs the Same as Stock Options? Key Differences

Companies often provide employees with equity compensation, which gives them an ownership interest. Two common types of equity compensation that are frequently misunderstood are Restricted Stock Units (RSUs) and stock options. Both aim to align employee interests with company success, but they operate with distinct mechanisms and tax implications. Understanding these differences is important for maximizing compensation value.

Understanding Restricted Stock Units (RSUs)

Restricted Stock Units (RSUs) represent an employer’s promise to deliver company stock shares to an employee at a future date. These units are “restricted” because they are subject to a vesting schedule, requiring the employee to meet specific conditions, usually continued employment over a set period, before gaining full ownership. A common vesting schedule might involve a portion of RSUs vesting each year over three to five years. Once the vesting conditions are satisfied, the shares are delivered to the employee.

Upon vesting, RSUs have inherent value, representing actual company shares or their cash equivalent. Employees incur no direct cost to acquire these shares once they vest; the shares are simply transferred. The fair market value of vested shares on the vesting date is treated as ordinary income to the employee, reported on their W-2. Employers withhold income and employment taxes (federal, Social Security, and Medicare) from the vested shares.

Employers often use a “sell to cover” method, automatically selling a portion of vested shares to cover tax withholding. If shares are held after vesting, any subsequent appreciation or depreciation is subject to capital gains tax upon sale. If sold within one year of vesting, gains are short-term capital gains, taxed at ordinary income rates. If held for over a year, they are long-term capital gains, taxed at lower rates.

RSUs do not confer voting rights or dividends until the shares are actually delivered upon vesting.

Understanding Stock Options

Stock options grant an employee the right, but not the obligation, to purchase company shares at a pre-determined “strike price” or “exercise price” within a specific timeframe. Stock options are subject to a vesting period, requiring the employee to remain with the company for a set duration, often several years, to earn the right to exercise them. Once vested, the employee can choose to “exercise” their options by paying the strike price to acquire the shares.

Stock options only hold value if the company’s stock market price is higher than the strike price. If the market price falls below the strike price, options are considered “underwater” and worthless. There are two primary types of stock options: Non-qualified Stock Options (NSOs) and Incentive Stock Options (ISOs). NSOs are more common and can be granted to employees, directors, or contractors.

When NSOs are exercised, the difference between the stock’s fair market value on the exercise date and the strike price (the “bargain element”) is taxed as ordinary income and reported on the employee’s W-2. Incentive Stock Options (ISOs) offer more favorable tax treatment but have stricter rules. ISOs can only be granted to employees and are not taxed at exercise for regular income tax purposes, though the bargain element can be subject to the Alternative Minimum Tax (AMT). To qualify for long-term capital gains treatment on ISO shares, specific holding period requirements must be met: shares must be held for at least two years from the grant date and one year from the exercise date. If these conditions are not met, the sale is considered a “disqualifying disposition,” and a portion of the gain is taxed as ordinary income.

Key Differences Between RSUs and Stock Options

A key difference between RSUs and stock options lies in their inherent value. RSUs retain value upon vesting as long as the company’s stock price is above zero, as they represent actual shares. Conversely, stock options only have value if the company’s market price exceeds the pre-determined strike price. If the stock price drops below the strike price, stock options may become worthless, offering no financial benefit to the employee.

The cost to acquire shares also differs significantly. With RSUs, employees do not pay any upfront cost to receive shares once they vest; the shares are simply delivered. For stock options, however, employees must pay the strike price to purchase the shares when they exercise their options. This required payment can be substantial, especially if the company’s valuation is high, representing a direct out-of-pocket expense for the employee.

Taxation timing and nature are another distinction. RSUs are taxed at vesting, with the fair market value of shares treated as ordinary income subject to federal, Social Security, and Medicare taxes. Stock options, particularly NSOs, are taxed at exercise, where the difference between the market price and strike price is recognized as ordinary income. ISOs have a different tax structure, often deferring regular income tax until the shares are sold, but they can trigger the Alternative Minimum Tax at exercise.

The risk profile associated with each compensation type varies. RSUs carry less downside risk once granted, as they will always have some value as long as the company’s stock does, providing a more stable form of equity compensation. Stock options, however, come with higher risk because their value is entirely dependent on the stock price appreciating above the strike price. If the stock underperforms, the options may expire worthless, resulting in no gain for the employee.

Finally, the impact on share count and dilution also presents a difference. RSUs are a promise of actual shares, and once they vest, they directly increase the number of outstanding shares, contributing to dilution. While stock options also lead to dilution when exercised and converted into shares, companies often grant fewer RSUs than stock options to provide comparable value, as RSUs are full-value awards. This can mean RSUs might result in less overall “equity burn” for the company to achieve a similar compensation value.