What Are Employee Stock Options and RSUs?
Money Girl explains different types of employee stock benefits and how they’re taxed.
You’ve probably heard about top employees at big companies who get paid stock options. No matter if you’re already one of them, or aspire to be one someday, you should know how these benefits work.
In this episode we’ll cover 2 types of employee stock benefits you might receive, in addition to a salary and other benefits. You’ll find out how stock benefits help you grow rich—plus, the huge difference in how they’re taxed.
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What Is an Employee Stock Option (ESO)?
An employee stock option or ESO is a benefit given to certain employees of a company. Stock options give you the right to buy shares of the company stock at a predetermined price. It’s called an option because you’re never obligated to buy in—it’s always your choice.
Benefits of Employee Stock Options
You might wonder why an employer would want to pay you with stock options, instead of simply increasing your salary or giving you a cash bonus. Well, shareholders always want the value of their stock to rise.
So, tying some or all of your compensation to the company’s stock price gives you an incentive to do an outstanding job, increase profits, and help the stock appreciate. This aligns shareholder and employee goals and makes everyone happy, in theory.
Employee Stock Option Example
Here’s an example of how a typical stock option benefit might work: Let’s say Cindy starts a new job with Acme, Inc. and is given 10,000 stock options as part of her compensation package. She has to wait a set amount of time, known as a vesting period, before she can exercise part or all of the option.
A typical vesting schedule might require her to wait a total of 3 years. For instance, Cindy might have the right to buy 2,000 shares after one year of service, 4,000 shares after working for 2 years, and the remaining 4,000 shares after 3 years.
I mentioned that options come with a predetermined price. So, let’s do the math if Cindy’s option price is $10 a share. After one year on the job, Cindy can exercise her right to buy as many as 2,000 shares at $10 each, for a total purchase price of $20,000.
Cindy’s been watching Acme’s stock price creep up to $15 a share. So, she decides to buy shares at $10 each. Then she turns around and sells those shares for a profit of $5 each. That could potentially give Cindy a total gain of $10,000 ($5 x 2,000 shares)—not bad!
But the downside of stock options is that Acme’s stock price could take a dive down to $8 a share and never climb above Cindy’s option price of $10. In that case, she’d never exercise her option because there’d be nothing to gain from buying stock at a price above its trading value. You make money by buying low and selling high. That means Cindy would miss the opportunity to receive a bonus, even if she’s been working hard.
See Also: Smart Moves to Start Investing on Any Income
How Are Employee Stock Options Taxed
Tax on stock options can be a little tricky. In most cases, you aren’t taxed for simply exercising your option to buy stock. However, if you decide to sell it, you’ll owe capital gains tax on your profit. You’ll also owe tax if you receive any stock dividends.
What Is a Restricted Stock Unit (RSU)?
Another type of employee stock benefit that you might receive is called restricted stock units or RSUs. Their purpose is similar to stock options: To encourage top performance and retain great employees. However, restricted stock is very different from stock options because you actually receive company stock. Remember that a stock option only gives you the right to buy stock at a specific price.
With a grant of RSUs, you typically receive a certain number of stock shares over a vesting schedule. The value of this benefit depends on the price of the company’s stock at the time your shares vest.
Let’s say Acme is really pleased with Cindy’s work and wants to keep her on board for at least 3 more years. They might give her 600 RSUs that are distributed over a 3-year vesting period. For instance, she would receive full ownership of 200 shares in one year, another 200 in 2 years, and the remaining 200 in 3 years.
If the value of Acme stock is $10 in one year when her first 200 RSUs vest, that’s a benefit of $2,000 ($10 x 200 shares) for Cindy. If the stock appreciates to $11 and $12 in the following years, she could potentially receive shares worth $2,200 ($11 x 200 shares) and then $2,400 ($12 x 200 shares).
See also: 6 Retirement Accounts Your Should Know About, Part 1
How Restricted Stock Units (RSUs) Are Taxed
Since Restricted Stock Units are considered income, they’re taxed in the year you receive them. Typically, a portion of your shares are withheld by your company to pay taxes, similar to how taxes are withheld from your wages. You receive the remaining shares as a net benefit and can sell them any time you like.
Having employee stock benefits is a great incentive to increase your company’s stock price and bottom line by increasing revenue, cutting expenses, or doing both. If your company issues stock and you don’t have stock benefits, talk to management about how you can become eligible. It may be possible if you create a plan to achieve aggressive company goals in your current position or gain the skills you need to land a future promotion.
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More Articles and Resources You Might Like:
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Employee vs. Independent Contractor
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About the Author
Laura Adams received an MBA from the University of Florida. She’s an award-winning personal finance author, speaker, and consumer advocate who is a frequent, trusted source for the national media. Money-Smart Solopreneur: A Personal Finance System for Freelancers, Entrepreneurs, and Side-Hustlers is her newest title. Laura’s previous book, Debt-Free Blueprint: How to Get Out of Debt and Build a Financial Life You Love, was an Amazon #1 New Release. Do you have a money question? Call the Money Girl listener line at 302-364-0308. Your question could be featured on the show.
