By Dustin Giannangelo
CEO Fusion Wealth Management
Do you currently own restricted stock units or stock options? Have you been given a choice to receive the equity portion of your compensation as a percentage of stock options or restricted stock units (RSUs)?
There is a lot of confusion between these two equity vehicles and how they work. Given that restricted stock units or stock options could make up a sizable portion of a professionals wealth it is imperative to understand the inner workings of them. If you want to successfully retire this is a must.
Companies such as The Illinois Central Railroad Company offered employee equity incentive plans to its workers back in the 1800s. We can thank companies such as these for starting employee equity incentive plans for their employees.
Things have changed quite a bit since then, and now it is a common practice where companies compensate at least a portion of their employees with equity incentives. Let’s take an in-depth look at the differences between the two and give you a clear understanding of which equity vehicle may best fit your needs.
What are Restricted Stock Units
Restricted stock units are a company’s promise to give you shares of the company’s stock or the cash value of the shares sometime in the future. When a company grants RSUs, it is typical to employees of the company, which usually consists of the directors and executive team. What you need to remember is that an RSU is non-transferrable. You must follow the guidelines of the RSU in compliance with the regulations of the Securities and Exchange Commission.
Most companies will place a vesting schedule of three years when they give an RSU. Meaning, you will have to hold the restricted stock unit for the allotted time before you can sell. Let’s say your vesting schedule was three years. Once you have owned the RSU for three years, you can then choose to sell it at the market price or continue to hold the units of stock. Also, it is essential to know that if your RSUs have not vested and you leave the company, then you lose those RSUs.
How do RSUs Work
People tend to get ownership of RSUs through a company merger, an initial public offering, a bonus, or as part of their salary. There are other ways people can accumulate RSUs, but for simplicity let’s stick with the most common methods. It’s important to know the truths about investing when making decisions about your RSUs.
Now, let’s take a look at the workings of an RSU with a real-world example. Let’s say that you received RSU’s when hired as a bonus or that you receive them annually as part of your regular compensation. If we fast-forward a few years, and your RSUs have now vested, you decide that you would like to sell the restricted stock units.
When your RSUs become vested, you pay ordinary income tax on the entire market value of the shares you received. The market value is the price you would have paid if you bought it in the stock market. Your company will usually handle the taxes on your behalf by withholding taxes automatically from the RSUs or via your regular paycheck. If you decide to hold the stock for a while and there is an increase in price you will pay taxes above whatever the stock price was on the day the stock vested.
Let’s say for example you have 400 RSUs that vested today. If you could buy your company’s stock today in the regular stock market for $200 per share, then you have effectively received $80,000 (400 RSUs x $200 per share) in income and owe taxes on that $80,000.
If you did sell immediately after vesting and receive the $80,000, then you should not owe any additional tax on the sale because you have already paid income tax on the value of the stock. Each company can have a different process on how they withhold taxes for your restricted stock units, so it is imperative you understand what possible tax implications there could be. You should always consult with a qualified tax professional before making any executions.
The Pros and Cons of RSUs
The most significant advantage of the RSU is that they do not have a strike price. Meaning, your cost basis for the stock is zero. This means that the RSU will continue to have value if the common stock holds a value.
This can be a significant advantage for the employee. The reason is that even if the company stock price does not increase in value, the stock you received would still have value. Since the RSUs do not have a strike price, they have improved downside protection for employees.
Most public companies are in favor of granting fewer RSUs since they hold more value for the employee. If we must consider the disadvantage of RSUs, then the only apparent downside is that the recipients of RSUs do not become shareholders until they receive the actual stocks.
What are Stock Options
Stock options represent the right to buy a company’s stock in the future at the price when you received the stock option. When a company grants stock options, they typically vest three years from the grant date. The holder of the options have an additional seven years from the vesting date to exercise them. The average period of an option is ten years after the grant date, three years of vesting, and seven years to exercise the option before it expires.
If you received stock options as a bonus or a part of your regular compensation, it is important to remember that companies will have a vesting schedule that you must adhere to before you can sell any of your stock options. The bet is that the company stock price will be significantly higher than the stock options in the future. Therefore, creating a substantial compensation benefit for the employee.
How do Stock Options Work
Stock options may be treated as an equity interest per the IRS and not income. The holder of an option (either Nonqualified Stock Options or Incentive Stock Option) does not pay any tax as the option vests, and if you never exercise your option, you will never pay tax.
The difference between NSOs and ISOs comes down to how they are taxed. NSOs are taxed at your ordinary income rate on the date of exercise. However, you will not pay any taxes on an ISO when you exercise the option, only when you sell it.
Most importantly if you hold on to your stock options for at least a year and one day after you have exercised them, then you will be taxed at capital gains rates, which are much lower than ordinary income rates. It is worth noting that If you exercise your options after they increase in value, but before they are liquid, then you are likely to owe an Alternative Minimum Tax. However, you do not have to sell your options, and you have seven years from the vesting date to decide when the best time is to sell your options.
Let’s look at a scenario where you currently have stock options. If you are granted 1,000 stock options this year when the price was $50 per share, and three years from now the price is currently $110 per share, you will pay only $50 per share to purchase the stock. In this example, you are yielding a significant gain because you were able to buy the shares at a deep discount in comparison to the current stock price.
The Pros and Cons of Stock Options
Stock options have favorable tax treatments because they may be treated as equity interests by the IRS and not income. Therefore, you have the potential to net a higher amount when exercising your options.
On top of favorable tax treatment, you have significant upside potential with your stock options. The future value of your options could rise dramatically above the current price, which could yield a substantial gain.
However, there is a certain amount of inherent risk associated with stock options. Your options could end up being worthless as well. If your options market value is not higher than the exercise price, then your options have zero value, which is important to understand if you work for a technology company. Therefore, the stability of the company and its ability to grow its stock price over the next few years is vital.
Restricted Stock Units vs. Stock Options
When comparing RSUs and stock options, it is critical to understand the difference in tax ramifications. RSUs are always taxed as regular income based on the fair market value on your date of vesting and your exercise price. Stock options, on the other hand, may be treated as equity interests and not income. Also, if you hold your stock once exercised for more than another year (at least 366 days), you will pay capital gains tax rather than income tax, which is significantly less. Therefore, stock options are more tax favorably than RSUs.
However, even though taxes are more favorable with stock options, they do have more inherent risk associated with them. Remember the stock options have no value if their market value is not higher than the exercise price, so you are betting on them appreciating in price. When it comes to RSUs, they are much safer because your grant price is usually zero, so any value above zero counts toward your compensation.
Stock options may have more risk associated with them than RSUs, but they do have more potential upside than RSUs. If the future value of your options rises dramatically above the current price, you could end up with a considerable gain. Since you are not forced to sell your options, you could wait up to seven years to continue to bet that the stock will keep appreciating in price. RSUs do not have this type of flexibility since they vest at the exercise date.
RSUs may not have the upside potential that stock options have, but they are much more simplistic. RSUs do not require extensive decision making. Once your shares vest you receive your shares, and the only decision you need to make is when to sell. Stock options have more complexity than RSUs since you need to decide when to exercise your option, sell your shares, and figure out your taxes.
|The value over time|
If the stock price is higher than the grant price, then the options have value. However, if the value is below or equal to the grant price, then the options will have no value.
|The RSU maintain their value whether the stock price decreases or increases.|
|The terms||The options tend to expire ten years after the grant date.||The RSU turns into shares at the time of vesting (3 years).|
|The options are 100% vested after three years.||The RSUs are 100% vested after three years.|
As you can see from the chart above, there are some similarities but also significant differences between these two financial vehicles.
Make Sure Your Goals are Aligned
There are instances when you will receive the option to choose RSU’s or stock options as part of your compensation. Therefore, you need to have a plan if you decide to take promised stock at a future date (RSUs) or stock options.
Before answering that you need to ask yourself a few questions first. What is your risk tolerance? Are you more conservative? If so, you are more than likely better off to choose RSUs over stock options.
How stable or what is the outlook for the company? Do you believe the stock price will increase significantly over the next three, five, or ten years? If all signs point to yes, and you are okay with more risk, then choosing stock options may be the better route.
Are you planning on selling the stock once it is vested? Will you keep a portion of the stock as a long-term investment? Should you sell all the stock and reinvest the cash into another asset class? You should have a clear and concise plan outlined that fits into your wealth plan.
You should have a clear idea when your RSUs or options will vest. The critical thing to remember about the vesting schedule is that it is time-based. Therefore, you will need to work with the company for a specified period until the vesting can take place. However, some executive’s vesting schedules can be performance-based.
Remember, if an employee gets terminated or leaves the company before they are vested, then the vesting stops immediately. Therefore, the employee may have to forfeit the unvested restricted stock units or stock options.
If any RSUs or stock options are granted to an employee before their termination date, then the employee has every right to keep those shares. Therefore, it is always imperative to understand the terms of any form of separation from the company so that you can weigh your options carefully.
It is imperative that you understand how your RSU’s and stock options work. With careful planning and due diligence, you could maximize your potential earnings with both vehicles. Do not wait until the last minute to put a plan in place and to understand these financial vehicles.
The opinions expressed in this commentary are those of the author and may not necessarily reflect those held by Kestra IS or Kestra AS. The material is for informational purposes only. It represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. It is not guaranteed by Kestra IS or Kestra AS for accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. Securities offered through Kestra Investment Services, LLC (Kestra IS), member FINRA/SIPC. Investment advisory services offered through Kestra Advisory Services, LLC (Kestra AS), an affiliate of Kestra IS. Fusion Wealth Management is not affiliated with Kestra IS or Kestra AS.
Securities offered through Kestra Investment Services, LLC (Kestra IS), member FINRA/SIPC. Investment advisory services offered through Kestra Advisory Services, LLC (Kestra AS), an affiliate of Kestra IS. Fusion Wealth Management, LLC is not affiliated with Kestra IS or Kestra AS. Kestra IS and Kestra AS do not provide tax or legal advice and are not Certified Public Accounting (CPA) firms. FINRA's BrokerCheck