RSU vs. Stock Options: Which Is Better?

Equity compensation provides employees with ownership in a business, aligning their interests with company performance. Stock options and Restricted Stock Units (RSUs) are common forms of equity compensation. These mechanisms can supplement traditional salaries, especially in growth-oriented companies or startups.

Understanding Restricted Stock Units

Restricted Stock Units (RSUs) represent a promise from an employer to deliver shares of company stock or their cash equivalent at a future date, provided certain conditions are met. Unlike stock options, employees do not pay to acquire RSUs; they are granted as part of compensation. RSUs hold no tangible value or ownership rights until they vest.

Vesting schedules are time-based, such as a percentage of shares vesting each year over a multi-year period (e.g., 25% annually for four years). Some RSUs may also have performance-based vesting, requiring the achievement of specific company or individual milestones. Once RSUs vest, they are settled, converting into actual shares that can be sold or held.

RSUs are taxed as ordinary income upon vesting, based on the fair market value of the shares at that time. This amount is included in the employee’s W-2 and is subject to federal, payroll, and potentially state and local taxes. Employers often withhold a portion of the vested shares to cover these tax obligations, a process known as “sell-to-cover,” resulting in the employee receiving “net shares” after taxes.

If the shares are held after vesting, any subsequent increase in value from the vesting date until the sale date is subject to capital gains tax. If these shares are sold within one year of vesting, the gain is taxed at short-term capital gains rates, which are the same as ordinary income rates. Holding the shares for more than one year after vesting qualifies any gain for lower long-term capital gains tax rates.

Understanding Stock Options

Stock options grant an employee the right, but not the obligation, to purchase a specific number of company shares at a predetermined price, known as the exercise price or strike price. This price is set at the stock’s fair market value on the grant date. Employees acquire ownership of these options over a vesting period, often spanning several years.

Two primary types of stock options exist: Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs). ISOs offer potential tax advantages and are exclusively granted to employees, adhering to specific Internal Revenue Service (IRS) requirements. NSOs, conversely, have more flexible terms and can be granted to employees, consultants, or board members, but they do not receive the same preferential tax treatment.

With NSOs, the difference between the exercise price and the stock’s fair market value on the exercise date is taxed as ordinary income. This tax event occurs upon exercise, even if the shares are not immediately sold, and is subject to income tax, Social Security, and Medicare taxes. Employers often withhold these taxes, through a “cashless exercise” where some shares are sold to cover the costs.

For ISOs, there is no ordinary income tax due at the time of exercise. However, the “bargain element”—the difference between the exercise price and the fair market value at exercise—is considered income for Alternative Minimum Tax (AMT) purposes. This can trigger an AMT liability, a separate tax calculation designed to ensure certain taxpayers pay a minimum amount of tax.

To receive favorable long-term capital gains treatment for ISOs, shares must be held for at least one year after exercise and two years from the grant date. If these holding period requirements are not met, the sale of ISO shares is considered a “disqualifying disposition,” and the gain may be taxed as ordinary income. Any appreciation in value after exercising an NSO or satisfying ISO holding periods is taxed as a capital gain upon sale, with long-term rates applying if held over one year post-exercise.

Comparing Restricted Stock Units and Stock Options

RSUs and stock options differ significantly in their inherent value and risk profiles. RSUs always carry value once vested, provided the company’s stock price is above zero, as they represent actual shares. This makes RSUs less risky than stock options, which can become “underwater” or worthless if the market price falls below the exercise price.

Taxation timing and type represent another major distinction. RSUs are taxed as ordinary income upon vesting, while NSOs are taxed at exercise, offering some control over the tax event timing. ISOs have a more complex tax structure, potentially triggering Alternative Minimum Tax (AMT) at exercise but offering capital gains treatment upon sale if specific holding periods are met.

Ownership is acquired differently for each. With RSUs, shares are automatically delivered to the employee upon vesting, requiring no active purchase. Stock options, however, require an active decision to “exercise” them, meaning the employee must purchase the shares at the predetermined exercise price. This requires a cash outlay from the employee to acquire the shares, whereas RSUs require no upfront cash investment.

The risk associated with each type of equity compensation also varies. RSUs offer more certainty of value because they convert into actual shares without an exercise cost. Stock options, particularly NSOs, involve more risk since their value depends on the stock price exceeding the exercise price, and exercising them requires an investment that could be lost if the stock declines.

Factors for Personal Evaluation

Evaluating equity compensation requires a personalized approach, considering an individual’s financial situation and career outlook. One important factor is personal risk tolerance. Individuals with a lower risk tolerance might find RSUs more appealing due to their inherent value and reduced risk of becoming worthless compared to stock options, which can lose all value if the company’s stock price declines significantly.

The company’s outlook and stock volatility also play a role in this assessment. For companies with high growth potential and expected stock appreciation, stock options could offer greater upside if the stock price significantly surpasses the exercise price. Conversely, for more stable companies with less volatile stock, RSUs might provide a more predictable and reliable compensation component.

Considering financial goals and liquidity needs is also important. If an individual anticipates needing access to funds in the short term, RSUs, with their automatic conversion to shares upon vesting, might be more straightforward. Stock options, especially ISOs, may require careful planning around exercise and holding periods to optimize tax outcomes, which could impact immediate liquidity.

An individual’s current tax situation and future tax planning are significant considerations. The immediate ordinary income taxation of RSUs upon vesting can mean a substantial tax bill for higher income earners. For stock options, particularly ISOs, understanding Alternative Minimum Tax (AMT) implications and planning for capital gains taxes upon sale is important to maximize after-tax value.

Integrating equity compensation into an overall personal financial plan is essential. This involves assessing how these awards fit with existing investments, savings goals, and debt management strategies. Consulting with a financial advisor can help in determining the most advantageous approach to managing and potentially diversifying equity compensation, ensuring it supports broader financial objectives.