What Is the Difference Between Restricted Stock and Stock Options?

Equity compensation aligns employee interests with company success and helps attract and retain professionals. This compensation grants employees a stake in the company. This article clarifies two common forms: restricted stock and stock options.

Understanding Restricted Stock

Restricted stock represents actual company shares granted to an employee. These shares come with conditions, typically a vesting schedule, that must be met before full ownership. Until vesting, the shares cannot be sold or transferred.

Vesting schedules can be time-based, requiring continued employment. They may involve annual vesting over several years or “cliff” vesting after a set period. Performance-based vesting requires achieving specific company or individual targets. Unvested shares are typically forfeited if an employee leaves the company.

Two primary forms of restricted stock are Restricted Stock Units (RSUs) and Restricted Stock Awards (RSAs). A Restricted Stock Award (RSA) involves the direct grant of actual company shares to an employee at the outset, though these shares are subject to forfeiture until vesting conditions are met. RSA holders may have voting rights and receive dividends on unvested shares, depending on the plan’s terms.

A Restricted Stock Unit (RSU) represents a promise to deliver company stock on a future date, once vesting is fulfilled. Actual shares are not issued at grant, and employees typically do not have voting rights or receive dividends until units vest and convert into shares. RSUs are often favored by companies as they do not dilute ownership until shares are issued upon vesting.

Understanding Stock Options

Stock options provide an employee the right, but not the obligation, to purchase company shares at a predetermined “strike price” within a defined timeframe. The strike price is typically the stock’s fair market value on the grant date. Employees usually exercise options when the company’s stock price rises above this strike price.

Stock options also come with a vesting schedule, dictating when an employee can exercise them. A common structure involves a multi-year vesting period, often with a “cliff” where no options vest until after an initial period. Unvested options are typically forfeited if an employee leaves the company. Once vested, employees can choose to exercise their options and purchase shares.

There are two main types of stock options: Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs). The primary distinction between these two types lies in their tax treatment, which can significantly impact the financial outcome for the employee. ISOs are subject to specific Internal Revenue Service (IRS) rules that can offer preferential tax treatment, provided certain holding period requirements are met. NSOs do not qualify for such special tax treatment and offer more flexibility in who can receive them, including employees, contractors, and board members.

Exercising stock options involves considering stock price, personal finances, and tax implications. Employees can pay cash for shares or use “cashless exercise,” where some shares are sold to cover costs and taxes. Understanding the grant’s terms is essential for financial planning.

Key Distinctions and Tax Treatment

The fundamental difference between restricted stock and stock options lies in what is initially granted: restricted stock involves the grant of actual shares (or the promise of them), while stock options grant the right to purchase shares in the future. With restricted stock, an employee receives company ownership once vesting occurs, whereas with stock options, the employee must actively purchase the shares after they vest.

Taxation is a significant distinction. For restricted stock, the fair market value of shares at vesting is typically taxed as ordinary income. This amount is reported on the employee’s W-2 and is subject to federal, state, and payroll taxes. If shares are sold immediately after vesting, capital gains tax is minimal. If held, any appreciation or depreciation from vesting until sale is subject to capital gains or losses.

For Non-Qualified Stock Options (NSOs), taxation occurs at two main points. When an employee exercises NSOs, the “bargain element”—the difference between the fair market value of the stock at exercise and the lower strike price—is taxed as ordinary income. This income is subject to federal, state, and payroll taxes, which are often withheld by the employer. When the shares acquired through NSOs are later sold, any additional gain or loss from the exercise date is treated as a capital gain or loss. If held for more than one year after exercise, the gain qualifies for potentially lower long-term capital gains tax rates.

Incentive Stock Options (ISOs) offer different tax implications. Generally, there is no ordinary income tax due at the time of exercise for ISOs. However, the difference between the strike price and the fair market value at exercise for ISOs is treated as income for Alternative Minimum Tax (AMT) purposes. This means employees may incur an AMT liability upon exercising ISOs, even if they do not immediately sell the shares. When shares acquired through ISOs are eventually sold, if certain holding period requirements are met (typically, holding the shares for at least two years from the grant date and one year from the exercise date), the entire gain is taxed at the more favorable long-term capital gains rates. If these holding periods are not met, the sale is considered a “disqualifying disposition,” and a portion of the gain may be taxed as ordinary income.

Regarding the cost to acquire, restricted stock typically has no upfront cost to the employee, other than the taxes paid upon vesting. Stock options, conversely, require the employee to pay the strike price to purchase the shares, which can represent a significant cash outlay. This difference impacts an employee’s immediate financial liquidity.

Regarding upside potential and downside risk, stock options offer leverage. If the company’s stock price increases significantly above the strike price, profit can be substantial. However, if the stock price falls below the strike price, options become “underwater” and can expire worthless, carrying significant downside risk. Restricted stock always retains some value as long as the company has value, even if the stock price declines. This provides a more predictable value, though less explosive upside than options.

The implications of leaving employment can differ. With restricted stock, unvested shares are generally forfeited. For stock options, employees typically have a limited window, often 90 days, after leaving to exercise vested options, or they risk forfeiture. These differences in mechanics and tax treatment necessitate careful financial planning, often with a tax advisor.