Stock Options vs. RSUs: Which is Better?

Equity compensation is a common component of employee benefits, particularly within high-growth industries and startups. It provides employees with a direct financial interest in the company’s success. Among the various forms of equity compensation, stock options and Restricted Stock Units (RSUs) are frequently utilized. Understanding these forms of compensation helps employees assess their total compensation and make informed financial decisions.

Understanding Stock Options

Stock options grant an employee the right, but not the obligation, to purchase a specified number of company shares at a predetermined strike price within a defined timeframe. There are two primary types: Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs), which differ mainly in their tax treatment.

The lifecycle of stock options typically begins with the grant date. A vesting schedule dictates when the employee gains the right to exercise their options. A common vesting structure might involve a “cliff” period, such as one year, during which no options vest, followed by gradual vesting over several years, often three to four years in total. Once vested, the employee can choose to exercise the options, meaning they purchase the shares at the strike price. Options can expire if not exercised within their specified term, potentially becoming worthless if the stock price does not exceed the strike price.

Understanding Restricted Stock Units (RSUs)

Restricted Stock Units (RSUs) represent a promise from an employer to deliver company shares once certain conditions are met, most commonly continued employment. Unlike stock options, RSUs represent actual shares, not just the right to purchase them. RSUs hold value as long as the company’s stock has value, as there is no exercise price to receive the shares upon vesting.

The RSU lifecycle also starts with a grant date. These units are subject to a vesting schedule, which specifies when the employee gains full ownership. Common vesting schedules for RSUs often include a time-based approach, such as a four-year period with a portion vesting annually, or a “cliff” vesting where all units vest at once after a set period, like three years. Once the vesting conditions are satisfied, the RSUs are distributed or settled, and the employee receives the actual shares. At this point, the employee becomes a shareholder and can choose to hold or sell the shares.

Taxation Considerations

The tax implications for stock options and RSUs vary significantly and are an important factor in understanding their overall value.

For Non-Qualified Stock Options (NSOs), there is no tax at grant. When exercised, the difference between the fair market value (FMV) and the strike price (the bargain element) is taxed as ordinary income, subject to federal income, Social Security, and Medicare taxes. Any subsequent gain or loss when shares are sold is a capital gain or loss.

In contrast, Incentive Stock Options (ISOs) receive more favorable tax treatment. There is no regular income tax at grant or exercise. However, the bargain element at exercise (the difference between the FMV and the strike price) is an adjustment for Alternative Minimum Tax (AMT) purposes, which may trigger AMT. To qualify for long-term capital gains rates, shares acquired through ISOs must be held for at least two years from the grant date and one year from the exercise date. If these holding periods are not met, a “disqualifying disposition” occurs, and the bargain element is taxed as ordinary income.

For Restricted Stock Units (RSUs), there is no tax at grant. The taxable event usually occurs at vesting, when the fair market value of the vested shares is taxed as ordinary income, similar to a cash bonus. Employers often withhold shares or cash to cover federal, state, and other applicable income taxes. When sold, any difference between the sale price and the fair market value at vesting is a capital gain or loss. If held for one year or less after vesting, any gain is short-term capital gain taxed at ordinary income rates; if held longer, it qualifies for long-term capital gains rates, which are generally lower.

Evaluating Your Equity Compensation

Stock options carry risk because they can expire worthless if the company’s stock price does not rise above the strike price. RSUs always retain some value as long as the company’s stock has value, as no purchase price is required upon vesting. Options offer greater upside potential but higher downside risk, while RSUs provide a more predictable and less risky form of compensation.

Several factors influence which type of equity compensation is more suitable. A company’s growth prospects play a role; if significant stock price appreciation is expected, stock options might offer greater potential return. In more established companies with stable growth, RSUs may be preferable due to their value and lower risk. An individual’s financial situation, including ability to cover exercise costs for options, also impacts the decision, as options require capital while RSUs do not.

Tax considerations and planning are important. The timing of taxation differs, with NSOs taxed at exercise and RSUs at vesting, while ISOs have complex AMT implications. An individual’s tax bracket and financial goals should align with the equity award’s tax treatment. Strategic planning with a tax professional can help manage tax liability.

The employee’s time horizon, or how long they plan to remain with the company and hold the shares, influences the value. Longer holding periods may allow for more favorable long-term capital gains rates for both types of awards.

How equity compensation fits into an overall diversification strategy is key. Concentrating wealth in an employer’s stock can introduce risk; diversifying by selling shares and investing in other assets helps manage this. The optimal choice depends on individual circumstances, financial goals, and the company’s equity program.