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When you take a new job, your salary may not be your only form of compensation. You’ll likely also receive benefits, vacation days and many times, some form of company stock. If you are offered stock, it will likely come in one of two forms: restricted stock units (RSUs) or stock options. Each of these carries its own benefits and disadvantages that are important to consider so you know which one is best for your financial plan.
A financial advisor can help you when choosing between stock options vs. RSUs for long-term growth.
What Are Stock Options?
A stock option lets you purchase equity in a company at an agreed-upon price within a set time period. Generally, one stock option contract represents 100 shares of the firm that you are buying into.
You do not have any obligation to purchase shares; rather, it is a company benefit in which you can choose to participate. This often involves a vesting schedule, where you have to work at the company for a certain period – often one year – before you can purchase the stock. This is to prevent temporary employees from ending up with potentially valuable stock.
One of the biggest benefits of stock options is their cost. Employees are offered shares at a set price that can be much less than its market value when the option actually vests.
Stock options may vest according to a specific schedule. For example, you may be able to exercise 250 shares per year for a total of 1,000 shares. There may also be an expiration date after which you are no longer able to exercise your right to stock options.
What Is an RSU?
Restricted stock units (RSUs) gained popularity during the 1990s and early 2000s as a straightforward alternative to stock options.
Unlike stock options, RSUs do not involve transactions or stock pricing. Instead, they represent a company’s promise to provide employees with stock once specific conditions are met. These conditions may be based on certain performance goals or a specified tenure with the company.
When the conditions are satisfied, the RSUs are typically converted into actual company shares or their cash equivalent, depending on the stock’s value at that time. The company may decide whether the payout will be in shares or cash, or it may allow the employee to choose.
RSUs usually vest over a set period, often several years. For example, many companies require employees to complete a full year of service before receiving any vested RSUs. After this initial period, it’s common for RSUs to vest incrementally, such as 25% or 20% of the total grant per year, while additional RSUs are awarded each month the employee continues to work at the company.
Stock Options vs. RSUs: Which Is Better?
There are pros and cons when comparing stock options vs. RSUs. Your choice will largely depend on your personal preferences, among other factors.
Understanding the difference in each category can help you make the right decision.
Stock Options vs. RSUs
| Characteristic | RSUs | Stock Options |
|---|---|---|
| Grant Date | Dated on issuance | Dated on issuance |
| Exercise Price | No exercise price | Set based on the full market value of underlying security |
| Vesting | Can be vested anytime for any milestone | Can be vested anytime for any milestone |
| Payment | Stock or cash | Stock |
| Taxation | Taxed on vested, treated as regular income (capital gains for stock held over a year) | Treated as regular income; ISOs as preferred items for alternative minimum tax |
Other Considerations Regarding Stock Options vs. RSUs
When evaluating equity compensation, the company’s stage is a key consideration.
Stock options are often a better fit for startups or early-stage companies that are unprofitable but have high growth potential. On the other hand, RSUs tend to be more advantageous at larger, well-established companies that are financially stable with predictable stock performance.
Stock options offer employees the chance for substantial gains if the company’s stock price increases significantly over time. However, they come with the risk that the stock price may stagnate or decline, leaving the options worthless.
In contrast, RSUs provide a more stable form of equity compensation. Their value does not depend on the stock price at the time of exercise or sale, making them appealing to employees who prefer predictable income and are less comfortable with market risks.
It’s also important to consider the company’s potential future performance. Stock options only have value if the stock’s market price exceeds the grant price during the vesting period. Otherwise, you could end up paying more for shares than their market value.
RSUs, by comparison, represent a net gain. That means there’s no upfront cost to acquire the shares, although you may owe taxes on the vested shares’ value. For these reasons, companies often grant fewer RSUs compared to stock options.
When deciding which is better for your investment strategy, consider your risk tolerance and financial goals. Stock options can be a worthwhile addition to your investment portfolio if you’re confident in the company’s growth and are willing to accept the associated risks. If you prioritize stability, RSUs may be the better choice.
Taxation for Stock Options vs. RSUs
Taxes are an important factor to consider.
Only income taxes apply when you sell RSUs immediately after vesting. This means no capital gains tax is due. However, if you sell the shares later, any appreciation over the share market price on the vesting date will be taxed as a capital gain.
Meanwhile, two types of taxes for stock options exist: non-qualified stock options and incentive stock options (ISOs).
- Non-qualified stock options. For non-qualified stock options (NSOs), you’re taxed on the difference between the market price and the grant price. This is called the spread, and it’s taxed as regular income. This means it’s subject to income tax and payroll taxes like Social Security tax and Medicare taxes.
- Incentive stock options. The spread on incentive stock options (ISOs), meanwhile, isn’t subject to payroll taxes. Instead, it’s a preference item for the alternative minimum tax (AMT) calculation. The alternative minimum tax can be complicated because it is a parallel tax system separate from regular tax laws. Therefore, enlisting the help of a financial advisor is often a good idea.
How Vesting Schedules Can Affect Your Compensation
Vesting determines when you gain ownership of stock options or RSUs, so the schedule has a significant influence on the value you actually receive.
Many companies use time-based vesting, often spread over several years with an initial cliff period. If you leave the company before vesting dates occur, any unvested equity is forfeited.
Stock options add an extra step because vesting gives you the right to exercise, not immediate ownership of shares. Exercising requires cash or a cashless transaction, and the value depends on the gap between the market price and the grant price on the exercise date. If the stock trades below the grant price, vested options may hold little or no economic value. RSUs convert into shares or cash when they vest, so their value reflects the stock price at that time without requiring an exercise decision.
Some employers use performance-based vesting tied to revenue milestones, product targets or individual performance measures. Depending on the results, vesting may accelerate, delay, or fail to occur.
Bottom Line
Stock options are when a company gives an employee the ability to purchase stock at a predetermined price at a given time. This may occur on a vesting schedule, where a number of shares become available each year over a series of years. Conversely, RSUs are grants of a stock that a company gives to an employee without any purchase. Employees get these either as shares or a cash equivalent.
Choosing between stock options vs. RSUs is a tough decision, as there are positives and negatives to both. Generally, it boils down to the fact that RSUs are less risky, as they don’t involve spending any money to get the stock. However, keep in mind that employees rarely have a choice. Therefore, it’s critical to understand what you’re offered and how it works before you make a decision on your full compensation package.
Tips for Investing
- If your employer is offering you stock options or RSUs, it might make sense to consult with a financial advisor. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area. You can have a free introductory call with your advisor matches to decide which one you feel is right. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- When you think about investments over a long period of time, don’t forget to factor in inflation. SmartAsset’s inflation calculator shows how the buying power of a dollar changes over time.
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