When you’re offered a new job, you’ll likely ask your new boss what benefits come with employment, ranging from healthcare and retirement plans to paid-time-off and sick days. Another benefit that some employers offer is stock in the company. A couple of ways that can be done is through stock options or restricted stock units. Understanding the differences between these two forms of compensation will help you adjust your financial plans accordingly.
Before we dive into the nitty gritty details about stock options and restricted stock units, it may be helpful to start with a definition.
- Stock Options – These allow employees to purchase equity in the company at a set price (the exercise price), for a set amount of time. Employees are not required to purchase the shares, but they can if they think it fits their personal financial circumstances and goals. You would only exercise the stock options if the exercise price is below the market price.
- Restricted Stock Units (RSUs) – These are a little more straightforward, as there is no transaction or stock pricing involved. Rather, the company commits to giving employees stock in the company when pre-determined requirements are met. These requirements might include performance or staying with the company for a certain amount of time.
Some employers allow employees to choose whether to receive options, RSUs, or both. Careful consideration (and reaching out to a financial advisor) can help determine your best choice.
Which Type of Share Works Better for You?
Evaluating these forms of compensation should be done on a case-by-case basis. What works for your coworker might not make the most sense for you. There are numerous benefits and drawbacks that you should consider before making a final decision:
- Taxes – Taxes are one of the most important factors to consider. When RSUs are first granted but still restricted no income tax is due.Once the restriction is removed it is counted as earned income and you will owe income tax. If you hold on to the shares, you may incur a capital gain and long or short-term capital gains tax may be due.
When evaluating stock options, understand there are two different types: non-qualified stock options (NSOs) and incentive stock options (ISOs). Employees with NSOs are taxed according to the difference between the market price and the stock option exercise price, which is the price at which you purchase the stock. This difference is called the “spread” and is taxed as regular income when the stock options are exercised. ISOs, on the other hand, are not subject to payroll taxes. Instead, these are taxed as capital gain when you sell the purchased stocks. Also, there may be an impact on your “alternative minimum tax” calculation. This calculation can be a little difficult – we recommend contacting a tax professional or financial advisor for assistance.
- Vesting – The vesting period outlines a certain amount of time before the RSUs or stock options are unconditionally owned by the employee. If an employee leaves the company or is terminated before the end of the vesting period, the company may buy back the vested units, they may revert back to the company without compensation, or they may give you an opportunity to exercise the stock options within a limited period. The employer will determine how stocks vest – whether they’re stock options or RSUs.
- Exercise Price – Stock options’ exercise price is the price at which a share may be purchased or sold. Options may expire without any value if the exercise price (also known as the strike price) is above the market price for the share when the option becomes exercisable. Options are “in the money” if the strike price is below the share price. RSUs, on the other hand, do not have an exercise price but the market price for the shares may be less on the date they become unrestricted than they were when the RSUs where first granted.
- Risk Tolerance – Your risk tolerance can also influence whether you choose stock options or RSUs. Stock options may provide greater upside potential – but could expire out of the money. RSUs provide something of value right away – though you may not be able to sell them right away. Other considerations include how you exercise your stock options: if you hold on to the stock or liquidate it right away. Or, with RSUs, you may decide to reinvest into a diversified portfolio. These are all important aspects to discuss with your financial planner.
Determining what form of shares work best for you can be a tough choice, especially because several factors can influence how the stocks affect your financial circumstances – and may have long-term tax consequences. If your employer is offering you shares in the company, it may be helpful to collaborate with a financial planner to determine what path makes the most sense for you, and how to position this compensation to yield the greatest possible benefit.