RSUs vs. Options: Tax Implications of Equity Compensation
Equity compensation is a critical component of remuneration. It offers immediate financial benefits and aligns you with your company’s long-term interests. Hopefully, what’s good for your company will be good for you. But you should understand the tax implications of RSUs vs. options.
Understanding RSUs vs. options
RSUs and options work pretty differently. RSUs are company shares given to employees as compensation but are subject to vesting. They can’t be sold until certain conditions are met. Stock options allow purchasing company stock at a predetermined price, offering potential significant gains if the stock price rises above this strike price.
Tax treatment of RSUs
RSUs are taxed as ordinary income when they vest based on the market value of the shares. Income generated from RSUs can push you into a higher tax bracket — upping your tax liability for the year. Some will sell a portion of the vested shares to cover the taxes. Others may defer income to avoid an income spike — pushing that tax burden off to a future year when you expect lower earnings.
Tax treatment of stock options
The tax treatment of stock options varies significantly between Non-Qualified Stock Options (NSOs) and Incentive Stock Options (ISOs).
NSOs are taxed as ordinary income upon exercise, based on the difference between the stock’s current market price and the strike price. This can also result in a substantial tax liability.
ISOs offer a favorable tax treatment as they are not taxed at exercise under the regular tax system, but they could trigger the Alternative Minimum Tax (AMT). Gains on ISOs held for more than one year after exercise and two years after the grant date are taxed as long-term capital gains, which have a lower tax rate than ordinary income.
When it comes to stock options, mistakes can mean you miss out on income or opportunities for growth. Consider the stock price, the timing of when you will sell, and your financial goals. There are a few strategies to consider.
The first is a “cashless exercise,” where you exercise your options, pay the tax burden from the options, and hold the company stock. This is a good option if you believe the stock will continue to increase in value. Another option to explore is filing an 83b election for your restricted stock units. This election lets you pre-pay your tax liability by asking the IRS to pay taxes on the stock’s fair market value at the time of the grant vs. when it vests. This could allow you to pay less in taxes if the stock price increases. When you sell your shares, you will be taxed on the gain at your applicable capital gains rate.
You can gift your NSOs. Once the option vests, it is considered a completed gift, and you may be able to take a deduction from your taxes. When it comes to stock options, there are many considerations, both financial and non-financial. Consult with a financial planner or tax advisor to develop a plan that best suits your needs.
Strategic tax planning with RSUs and stock options
Effective tax planning with RSUs and stock options requires careful consideration of exercise timing and sale of shares. For stock options, particularly ISOs, you might plan your exercises around years when your other income is lower to reduce the likelihood of triggering AMT. With RSUs, consider whether it makes sense to delay any discretionary additional income into years when RSUs do not vest. Think about having a detailed, year-by-year plan for your equity compensation — perhaps with your own personal CFO.
Navigating the tax implications of RSUs vs. options requires strategic planning and a thorough understanding of your compensation package. By carefully considering how and when to exercise these options and sell shares, you can significantly minimize your tax burden and maximize the value of your equity compensation.
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