Restricted Stock Units (RSUs) and stock options are two forms of compensation offered by companies to their employees. RSUs involve a commitment from the employer to provide equity compensation in the form of shares at a future date, and once vested, employees can either sell or retain the shares. On the other hand, stock options grant employees the right to purchase company stock at a predetermined price within a specified period.
Once RSUs have vested, the employee receives the shares and can either sell them or retain them. However, employees given stock options are not obligated to exercise the option, which means to purchase the stock and can choose to let the option expire.
If you are trying to decide between RSUs and stock options, this article aims to explain the key distinctions between these two forms of equity compensation. We will guide you through the benefits and drawbacks of each offering examples of how they can be strategically utilized to meet financial goals.
RSU vs. Stock Options
RSUs and stock options are both forms of compensation used by companies to retain employees and foster a sense of belonging by providing them with a stake in the company. To effectively compare these two forms of compensation, it is necessary to understand their meanings and how each of them operates.
What is RSU?
RSU stands for restricted stock units, representing an equity compensation provided by companies to their employees. With RSUs, the company commits to granting the employee a specific number of shares of its stock at a future date.
The shares are usually awarded to the employee once certain conditions, such as a specific timeframe or the achievement of particular performance goals, are fulfilled. Upon the vesting of RSUs, the employee receives the shares and can choose to sell them or retain ownership.
Companies use RSUs to give employees a sense of connection to the company, as having a stake in the workplace tends to instill a feeling of ownership. This sense of ownership often contributes to employees’ commitment to the company’s success.
Once the RSUs have vested, the value of the shares at the time of vesting is taxed as ordinary income, and any further gains or losses incurred upon selling the shares are taxed as capital gains or losses.
What are stock options?
Stock options are another form of equity compensation that companies offer to their employees. With stock options, the company provides its employees with the opportunity to purchase a specific number of shares of the company’s stock at a pre-determined price, called the exercise price.
The employee can exercise this option by buying the shares at the exercise price within a specified timeframe. If the stock price rises, the employee can buy the shares at the exercise price and sell them at the higher market price, making a profit.
However, if the stock price decreases, the employee is not obligated to purchase the shares and can allow the option to expire.
Similar to RSUs, stock options can be a valuable form of compensation, as they offer employees the potential to benefit from the company’s success without investing their personal money in company stock.
Difference Between RSUs and Stock Options
Although RSUs and stock options effectively compensate employees, they differ in certain aspects. The key distinction lies in what is received RSUs involve the granting of stock once the vesting period concludes, and there is no requirement for the employee to make any payment for the stock. In contrast, with stock options, upon receiving the option to purchase company stock, there is a predetermined date for the employee to make the purchase. During the specified timeframe, the employee has the choice to buy the stock or allow the option to expire, as it is not obligatory.
Here are further differences between RSUs and stock options:
| Factor | RSUs | Stock Options |
| Definition | Promise of future company shares | Right to buy company shares at a set price |
| Exercise Price | No exercise price, as shares are granted | The exercise price (strike price) is predetermined |
| Vesting | Time-based or performance-based | Typically, time-based |
| Taxation | Taxable at vesting | Taxable at exercise |
| Withholding | Withholding may occur for taxes | Withholding may occur for taxes (at exercise) |
| Ownership | Immediate ownership after vesting | Ownership upon exercise, subject to vesting |
| Payment Required | No payment is required for shares | Payment required to exercise options |
| Common Use | Common in various industries | Common in tech startups and high-growth firms |
| Favorability for Employees | It may be favorable for those seeking ownership without upfront costs | It may be advantageous for those anticipating stock price growth, willing to take risks |
RSU vs. Stock Options Tax Implication
Both RSU and stock options have distinct tax implications due to their differing structures. While the table above outlines the tax implications of each, it is important to elaborate on these implications further.
RSU Tax Implications
RSUs grant ownership of stock rather than an option to purchase stock, resulting in different tax implications compared to stock options. Tax is incurred when RSUs vest and employees are required to pay taxes on the value of the vested RSUs. Employers may withhold a portion of an employee’s RSUs to cover tax obligations or offer the option to settle taxes in cash, allowing the employee to receive their vested RSUs in full.
RSUs are taxed as ordinary income, with rates ranging from 10%–37%. Also, they can be withheld for medical and social security taxes, which can result in an additional 7.65% tax payment. State taxes may also apply depending on the employee’s state of residence.
Stock Options Tax Implication
When granted stock options, taxes are incurred only upon exercising or selling the stock. Exercising the option is not mandatory, allowing flexibility in managing tax obligations. The tax treatment depends on the type of option granted.
In the case of Incentive Stock Options (ISOs), there is no tax upon exercising the option. However, the stock acquired through the exercise of ISOs is sold, and the gains are subject to taxation. For these gains to qualify for favorable tax treatment, the stock must be held for at least two years from the grant date and one year from the exercise date. If these holding period requirements are met, the gains are taxed as long-term capital gains, which generally carry lower tax rates compared to ordinary income. If the stock is sold before meeting these holding period criteria, the gains will be treated as ordinary income..
Non-Qualified Stock Options (NSOs) are taxed as ordinary income based on the difference between the stock’s fair market value and the exercise price at the time of option exercise. When the stock acquired through the exercise of NSOs is sold, any additional gain or loss is subject to capital gains tax. If the stock is held for more than one year after exercising the NSOs, the gains are considered long-term capital gains, which typically have lower tax rates than ordinary income. However, If the stock is sold before meeting the one-year holding period, any additional gain or loss will be treated as a short-term capital gain or loss, taxed at the employee’s ordinary income tax rate.
RSU vs. Stock Options: Which Is Better?
RSUs and stock options each have their own set of advantages and disadvantages, so making the choice between them depends on your specific preferences. RSUs are often likened to a gift, as they are granted to employees without requiring an initial purchase and exclusively upon the attainment of milestones or the fulfillment of specified requirements.
However, RSUs are subject to taxation as ordinary income upon vesting, with the possibility of a portion being withheld for tax payment, similar to salary taxes. It is important to note that some companies may permit cash payment for RSU taxes.
On the other hand, stock options, which must be purchased, are not taxed until they are exercised, but if they are exercised and held for at least a year after exercising them, they will be taxed at a favorable capital gain tax rate. While the potential for profit exists if the stock price appreciates, the risk lies in potential losses if the stock price fails to rise, leading to a situation where shares cost more to acquire than they can be sold for.
Overall, the decision between RSUs and stock options is nuanced, with each having distinct merits and drawbacks, and the optimal choice depends on individual preferences and the unique circumstances of the company and its employees. It is crucial to assess the company’s potential when deciding between RSUs and stock options, ensuring alignment with employee preferences and the company’s strategic objectives.
What Is a Good RSU Offer?
A good RSU offer should provide enough value to the employee’s contributions to advancing the company’s success. The RSU vesting schedule should align with the employee’s goals, and negotiation may be warranted if the terms seem unfavorable. Consider the following factors:
- Number of RSUs: A substantial number of RSUs can provide a significant financial benefit if the company performs well.
- Vesting Schedule: Carefully evaluate the vesting schedule to ensure it aligns with your goals and expectations.
- Company Performance: Company performance matters. A well-performing company can potentially enhance the benefits derived from RSUs.
- Stock Price History: Analyze the company’s historical stock price performance. If there is consistent growth, there is a potential for favorable returns on your RSUs.
- Compensation Package: Evaluate the RSU offer alongside your entire compensation package, including salary, benefits, bonuses, and other perks. A well-rounded package is always more attractive.
Conclusion
RSUs and stock options are widely employed by companies as valuable forms of employee compensation, offering significant advantages. However, it is crucial to grasp the tax ramifications associated with both. Seeking guidance from financial and legal experts is recommended to determine the most suitable option for your individual circumstances.