Importance of understanding equity compensation

Equity compensation is a form of non-cash compensation that companies sometimes offer their employees, especially executives. Equity compensation either directly gives an employee shares in the company or gives them the right to purchase shares.

A key benefit of equity compensation is that it gives employees some ownership of the company and allows them to benefit from the company’s performance. Equity compensation is designed to help with employee retention and morale.

Read more: Equity compensation: An employee guide

Overview of restricted stock units and stock options

Stock options and restricted stock units (RSUs) are two popular forms of equity compensation. They both offer employees the opportunity to have equity in the company but in distinct ways. Stock options and RSUs differ in terms of how they work, how they are taxed, and more.

Stock options explained

Definition and characteristics

Stock options are probably the most well-known form of equity compensation. A stock option is the right to buy a specific number of shares of company stock at a pre-set price, known as the “exercise price” or “strike price,” for a fixed period of time, usually following a predetermined waiting period called the “vesting period.”

With stock options, you can pursue different tax treatment by waiting until you hit certain milestones, such as owning the stock for at least two years after the grant date of the options and one year after you exercise your options to sell your shares (This holding period applies to incentive stock options). However, every situation is unique and high-level guidelines may not make sense for everyone to follow. For example, in some cases it may be better to exercise and immediately sell, such as in situations where the main goal is reducing portfolio risk.  You may want to check with a financial professional to see which strategy makes the most sense for you.

Read more: What are stock options & how do they work?

Vesting period and milestones

The vesting period is one of the most important characteristics of stock options since it determines when you can actually purchase the stock.

Most vesting periods span three to five years, with a certain percentage of options vesting over time (which means when you actually own your options), though you still need to exercise (i.e., purchase) them.

For example, let’s say you get 100 stock options as a part of your company’s benefits package. If you have a four-year vesting schedule, you might be granted 25 options in the first year, 25 options in the second year, and so on.

Read more: What is a vesting period?

Tax implications

You don’t usually have to worry about paying taxes on your stock options when your company grants them. Instead, there’s no taxable event until you exercise your options and/or sell the stock, depending on the type of options.

If you have incentive stock options (ISOs), then your options may generate an alternative minimum tax (AMT) bill when you exercise them and hold the shares past year-end.  The AMT liability, if any, depends on the difference between the exercise price and the stock’s fair market value when you exercise. When you sell the stock, gains are generally taxed as long-term capital gains if you’ve held the stock for at least two years after the option was granted and at least one year after you exercised it. If you exercise and sell the shares before the above holding period has elapsed, all gains are generally taxed at ordinary income rates.

Non-statutory stock options (NSOs), sometimes referred to as non-qualified stock options, may be taxed when you exercise them. You’ll pay ordinary income taxes on the difference between the exercise price and the stock’s fair market value when you exercise them. Gains are usually taxed as long-term capital gains if you sell the stock at least one year after exercise.

Cautionary note

Everyone’s financial situation is unique. While we can provide broad information about how stock options and other forms of equity compensation work, taxation and other factors may vary depending on your unique situation. It’s important to seek the help of a financial or tax professional who can provide personalized advice specific to your situation.

RSUs unveiled

Definition and key features

RSUs are a type of compensation where the company promises to pay you a certain amount of shares over time. The shares don’t truly belong to you until their “restriction” goes away.

These can be performance or timing restrictions, similar to restrictions for options. You can think of restricted stock units as a bonus awarded as stock instead of cash. However, like cash, it is generally taxed at vesting as if it were paid in cash (i.e., as ordinary income).

When you’re offered RSUs as a form of compensation, your RSU agreement will explain how many shares you’re set to receive and their vesting schedule. For example, suppose your RSU agreement states that you’ve been granted 100 RSUs vesting annually in equal portions over 4 years. Each year, you would vest 25 shares, which will be worth whatever the share price is on the vesting date.  If the shares are worth $20 on the first vesting date, they’ll be worth $500 and generate $500 of ordinary income, at which point you can either keep the shares or sell them (selling typically realizes no gain or loss if you sell right at vesting).

Restricted stock units can be a popular alternative to stock options, particularly for executives, due to their favorable accounting rules.

At first glance, RSUs appear to be quite similar to stock options. While there are certainly some similarities, RSUs and stock options are two entirely different things.

Vesting process

RSUs can be awarded on regular vesting schedules or performance benchmarks, which means that the value of the RSUs on the day of vesting is subject to payroll and ordinary income taxation. Upon vesting, you’ll get your equivalent shares and realize ordinary income based on their value that day.

Taxation implications

Because RSUs grant you stock rather than the option to purchase stock, the tax implications are different. You’ll have to pay taxes on RSUs when they vest. Usually, an employer will withhold some of your RSUs to cover your tax burden. In some cases, you may be given the option to pay the taxes in cash so you can receive the full amount of your vested RSUs.

RSUs are taxed as ordinary income, meaning the rate you’ll pay can get as high as 37% at the federal level, depending on your household income. They are also subject to withholding for Social Security taxes and Medicare taxes, which will result in another 7.65% in tax liability. Finally, depending on where you live, your RSUs may be subject to state income taxation.

RSUs vs. stock options: What’s the difference?

RSUs and stock options are two popular forms of equity compensation. While both offer employees a similar benefit — the chance to have equity in the company — they do so in very different ways. They are very different in their common uses, how the employee accesses the stock, their taxation, and more.

The most important distinction between stock options and RSUs is what exactly you’re receiving. When you’re granted stock options, you literally have the “option” to purchase company stock at a specific price before a certain date. Whether, and when, you actually purchase the stock is entirely up to you. RSUs, on the other hand, grant you the stock itself once the vesting period is complete. You don’t have to purchase it.

The table below breaks down some of the key features of both stock options and RSUs and how they differ from one another:

	Stock options	Restricted stock units
Key benefit	Employees have the right to purchase shares of company stock at the strike price	Employees receive shares of company stock
Action required	Employee must exercise the options to get stock	No action is required by the employee to get stock
Exercise price	Generally based on the stock’s fair market value near the grant date	None
Vesting	Usually awarded on a set time-based vesting schedule	Usually awarded on a set vesting schedule based on time and/or company liquidity event
Taxation	Potentially taxed at exercise, then again at sale depending on the stock price at purchase vs. sale	Taxed when vested, and potentially again if the stock goes up after vesting but before sale
Common uses	Early or mid-stage start-ups	Late-stage start-ups and public companies

Are RSUs worth it?

RSUs are a common form of equity compensation that let employees participate in the company’s success.  They’re often granted in addition to regular cash compensation, so they can be viewed as an added bonus, though the value is unknown until they vest.

When you’re granted stock options, you’re given the opportunity to purchase company shares in the future at the strike price. While you may be able to get the stock at a discounted price, you still have to pay for it. RSUs, on the other hand, are compensation in the form of stock. Unlike stock options, you won’t have to pay for your shares.

As an employee, you may have the choice between stock options and RSUs, but most of the time the company will decide which to offer. That being said, both types of equity instrument can definitely be worth it if your company offers them since they’re essentially extra compensation.

Our take

Stock options and RSUs are both popular forms of equity compensation and can potentially result in becoming a significant piece of your net worth:

• RSUs are an excellent form of compensation if you’re offered them, but they also come with tax implications, as they are taxed as ordinary income as soon as they become vested.
• Stock options offer large potential upside as well as the choice around when to exercise and realize the taxes, if there are any.

No matter what form of equity compensation you’re offered, it’s important to fully grasp its tax implications and how your equity might weigh on your overall portfolio. Understanding your complete compensation package is just one part of your overall financial plan. Consider talking to a financial professional for guidance on equity compensation strategies.