Equity compensation is a way for companies to offer shares of ownership in the company as a form of payment. Similar to health insurance coverage and paid time off, equity compensation is a form of non-cash payment companies use to attract and retain valuable employees.
Restricted stock units (RSUs) and stock options are two types of equity compensation that companies can offer. One allows employees to earn company stock simply based on their years of service with the company or by reaching certain goals, while the other allows employees to buy stock, often at a below-market price.
What’s the Difference Between RSUs and Stock Options?
|Restricted Stock Units||Stock Options|
|Gives the employee company stock without requiring payment||Gives an employee the right to buy company stock at a strike price|
|Valuable as long as the market price is above $0||Valuable when the strike price is less than the market price|
|Taxed as ordinary income when vested||Non-qualified stock options (NSO): Taxed as ordinary income when exercised
Incentive stock options (ISO): Taxes deferred until the stock is sold
How They Work
RSUs and stock options are both forms of equity compensation, but they work a bit differently, especially when it comes to how the employee actually acquires them.
A restricted stock unit (RSU) is stock that a company offers an employee as a form of compensation. RSUs typically have a vesting schedule that restricts the employee from purchasing the stock except in certain circumstances. For example, the company may have a policy that an employee becomes vested in a certain number of shares each year.
The company also may tie the RSUs to performance, so an employee becomes vested when they reach certain goals. This type of vesting schedule is less common, and is usually reserved for highly paid employees and company officers.
An employee stock option plan is also a form of equity compensation, but unlike in the case of RSUs, the employee doesn’t simply receive the stock. Instead, the stock option gives the employee the right to purchase stock at a particular strike price. An employee can exercise their stock options at any point during the exercise period, which typically lasts 10 years.
Another difference between RSUs and stock options is their value. RSUs are a form of equity compensation that doesn’t require the employee to pay for them. Because you as an employee don’t have to make a financial investment in the RSUs, they’re valuable as long as the stock’s market price is above $0.
In the case of stock options, the employee acquires them by purchasing them at the predetermined strike price. And they really only hold value if the strike price allows you to purchase them for less than the current market price.
Imagine you had employee stock options that allowed you to buy company stock for $10 per share. However, because of poor financial performance the previous quarter, your company’s stock price slipped to $8. Your stock options don’t hold value because it would make more sense for you to simply buy the stock through an exchange rather than by exercising your options.
Another key difference between RSUs and stock options is the way they are taxed. RSUs are taxed as ordinary income. It doesn’t matter when the RSUs are granted; they aren’t taxed until they become vested.
Suppose that as a part of your compensation, you were granted RSUs that would vest over a period of four years, with you receiving one-quarter of the stock each year. When you file your taxes for the next four years, you would claim one-quarter of the total RSUs as ordinary income, because that’s the amount that would have become vested that year.
The tax treatment of stock options varies depending on the type of option. Non-qualified stock options (NSO), which are the most common type, are taxed when they are exercised. You aren’t taxed on the full value of the stock, however. You’ll only be taxed on the difference between the purchase price and the current market price.
The other type of stock option is an incentive stock option (ISO). You don’t have to pay taxes when you exercise this type of option. Instead, taxes are deferred until you sell the stock.
It’s also important to note that for both RSUs and stock options, you’ll be subject to taxation when you sell your shares. In general, if you hold your shares for less than one year before you sell, you have a short-term capital gain, and your profit will be taxed as ordinary income. If you hold your shares for more than one year, you have a long-term capital gain, and your profit will be taxed at a rate of 0%, 15%, or 20%, depending on your income for the year.
It’s important to note that to qualify for long-term capital gains tax treatment when you sell your incentive stock options, you must hold the shares for at least one year after you exercise the options, and at least two years after they were granted. So it’s possible that if you exercise the options shortly after they’re granted, you could hold the shares longer than one year and still be subject to short-term capital gains tax treatment.
Which Is Right for You?
As an employee, whether you have access to RSUs or stock options will depend on the company you work for. Some companies may offer one or the other, while others may offer both.
Both RSUs and stock options come with significant benefits. In the case of RSUs, you receive the stock units at no cost to you. Regardless of the price of the stock when you become fully vested, they provide value to you. However, the full value of the units you receive will be taxed as ordinary income.
Your tax burden will be lower than with RSUs because you’re typically only taxed on the difference between the market price and the strike price.
Stock options, on the other hand, require that you pay for the stock you acquire. The stock’s market price, when compared with the strike price, will determine just how valuable your options are.
Company Stock in Your Investment Portfolio
If your company offers either RSUs or stock options, it’s important to consider how those shares will fit into your overall investment portfolio. Allowing a single company—even the one you work for—to comprise too large a share of your portfolio could create unnecessary risk and the chance of excessive loss if the company underperforms.
Charles Schwab recommends limiting your employer’s stock to 20% or less of your portfolio, while T. Rowe Price recommends keeping it below 5%. Ultimately, you’ll have to decide, based on your own situation, how much of your portfolio you’re comfortable dedicating to your company’s stock.
There are several different rules of thumb as to how much of your portfolio should be allocated to own-company stock. Some factors you may consider include your risk tolerance, the size of your portfolio, and your confidence in the company you work for.
The Bottom Line
RSUs and stock options are both types of equity compensation that companies may offer their employees as a way to attract and retain talent and reward them for hard work. Which you have access to will largely depend on the company you work for and your role within it.
Some companies offer RSUs, while others choose stock options. Additionally, some companies only offer these forms of compensation to certain employees within the company. Ultimately, RSUs and stock options are additional forms of compensation, such as your paycheck, 401(k) match, and health insurance plan, and are factors you should consider when accepting a job offer.
Congressional Research Service. "Employee Stock Options: Tax Treatment and Tax Issues."
T. Rowe Price. "How Much of My Employer’s Stock Should I Own?"
Charles Schwab. "Understanding the Risks of Employee Stock Options."