Stock options and RSUs differ in terms of their vesting, the form of compensation the employee receives and how they are taxed.

When considering your overall compensation, you should pay attention to what’s beyond your paycheck. Stock options and RSUs are both common vehicles used by employers to compensate their employees with equity, but companies don’t always educate their employees on what their holdings are actually worth. The first step toward understanding the value of your equity is to simply understand the ins and outs of what these holdings are and how they work.

RSUs and stock options are both forms of employee equity compensation — or non-cash compensation — offered to an employee by an employer. RSUs and options are generally the most common forms of equity compensation, but they require different strategies.

Stock options and RSUs

Before we dive into the differences between stock options and RSUs, we should first explain a bit about each one and how it works.

What are stock options?

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” or “strike price,” for a fixed period of time, usually following a predetermined waiting period called the “vesting period.” Most vesting periods span three to five years, with a certain percentage of options vesting each year (which means you’ve “earned” your shares), though you still need to exercise (i.e., purchase) them.

With stock options, if you wait to hit certain milestones, your tax treatment may be better. You could receive favorable tax treatment if you wait for two years from the grant date and one year from the date of exercise to sell your shares. Once these two milestones are met, any profit you generate from the sale of your stock will be taxed as long-term capital gains. (Note: This holding period is only applicable to incentive stock options, and you could be subject to taxation when you exercise the share.)

Keep in mind that these are very high-level guidelines; since every situation is unique, you should check with a professional to see if these apply to you.

What are RSUs?

RSUs are a type of restricted stock (which may also be known as “letter stock” or “restricted securities”). Restricted stock is company stock that cannot be fully transferable until certain restrictions have been met.

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

Restricted stock can be a popular alternative to stock options, particularly for executives, due to their favorable accounting rules and income tax treatment. There are two basic types of restricted stock: restricted stock awards (RSAs) and RSUs (as noted above, restricted stock units).

How do RSUs work?

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. RSUs are issued in the form of units — not stock — that correspond in number and value to a specified number of shares of employer stock. Upon vesting, you’ll get your equivalent shares.

Is an RSU a stock option?

At first glance, RSUs and stock options appear to be quite similar, and you might find yourself wondering whether an RSU is a stock option. While there are certainly some similarities, RSUs and stock options are two entirely different things.

Does one RSU equal one stock?

When you’re offered RSUs as a form of compensation, your RSU agreement will explain what each unit is worth. Each RSU will correspond to a certain number and value of employer stock. For example, suppose your RSU agreement states that one RSU corresponds to one share of company stock, which currently trades for $20 per share. If you’re offered 100 RSUs, then your units are worth 100 shares of stock with a value of $2,000.

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

Stock options and RSUs both allow companies to offer additional compensation, either in the form of stock or the opportunity to buy stock at a discounted price.

The most important distinction between stock options and RSUs is what exactly you’re receiving. When you’re granted stock options, you have the option to purchase company stock at a specific price before a certain date. Whether 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.

Other important differences between stock options and RSUs include their grant dates, exercise price, vesting, payment and taxation. We’ll explain some of those differences in the table below.

Are RSUs worth it?

While stock options are the most popular form of equity compensation, RSUs tend to be a bit more difficult to come by and are often reserved for company executives and key employees.

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 not have the choice between stock options and RSUs — the company will decide which to offer. That being said, RSUs can definitely be worth it if your company offers them since they’re essentially free stock.

Tax implications of stock options and RSUs

In the table above, we briefly explained the difference between the tax consequences of stock options and RSUs in terms of when each is taxable. In this section, we’ll dive a bit further into how you’ll be taxed on each form of equity compensation.

Tax implications of stock options

You don’t 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 or sell the stock, depending on the type of options.

ISOs: Not taxed when you exercise the stock. Gains are taxed as long-term capital gains as long as you hold the stock for at least two years after the option was granted and at least one year after you exercised it.

Non-statutory stock options (NSOs): Taxed as ordinary income on the difference between the exercise price and the stock’s fair market value when you exercise them. Gains are taxed as long-term capital gains if you hold the stock for at least one year.

Tax implications of RSUs

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 are vested. In many cases, an employer may withhold some of your RSUs to cover your tax burden. In other 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 range from 10% to 37%, 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.

Stock options vs. RSUs: Which is better?

There are benefits and drawbacks to both stock options and RSUs. Deciding which one is better will depend on your individual circumstances and other factors, including taxation. RSUs are taxed at ordinary income tax rates as soon as they become vested and liquid. Employers usually withhold some of the RSU to pay taxes, just like they withhold a portion of salary and wages to pay income taxes, though you might be given the option to pay taxes with cash on hand so you can retain all your vested RSUs.

In contrast, stock options aren’t taxed until they are exercised. If you hold onto stock options for at least one year, they will be taxed at more favorable capital gains tax rates. Stock options usually aren’t exercised until after a company goes public, when the employee can sell enough shares to cover the tax owed on the appreciation.

Another important consideration is that stock options only have value if the price of the stock goes up in the future. If the stock price doesn’t rise, then you’d have paid more for the shares than you can sell them for. The value of RSUs, on the other hand, isn’t contingent on the stock price rising in the future. They are simply awarded by the company when certain performance requirements are fulfilled or after you’ve worked at a company for a certain period of time.

This is one reason why RSUs tend to be less common than stock options. If given the choice, you should weigh the potential benefit of major price appreciation that could make stock options extremely valuable in the future against the risk that the stock price doesn’t appreciate at all and the options are worthless. In contrast, RSUs tend to be a relatively good option because their value doesn’t depend on stock price appreciation.

Our take

Stock options and RSUs are both popular forms of equity compensation and can ultimately result in a significant piece of your net worth. Therefore, it’s important to fully understand 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 fiduciary financial advisor for guidance on financial strategies.