RSUs, NQSOs and ISOs: What's the Difference? | Consilio Wealth Advisors (2024)

Are you searching for more information on the differences between an RSU vs options like NQSOs and ISOs? To get the right stock options for your needs–and for valuable advice on using these options–read on.

Leading companies in the tech industry offer many forms of employee compensation–including stock compensation. But, they aren’t all the same. It’s important to understand the factors separating stock compensation varieties like non-qualified stock options (NQSOs) and incentive stock options (ISOs) from restricted stock units (RSUs).

RSU vs Options

First, let’s look at the differences between RSUs and stock options. These are both stock-related benefits, but they differ in terms of vesting schedules, taxation, and the type of compensation you’ll receive.

What Are RSUs?

If you’re working for a publicly traded tech company, there’s a good chance you already know about RSUs. These stock units, which equate to shares in your employer’s stock, are a vital element of many employee compensation packages in the industry. While valuable, they hold no value to the employee until the vesting requirements are met, which are based on the amount of time working with the employer.

An Example

You are granted $50,000 worth of RSUs that vest 25% per year over 4 years. This is worth nothing to you today. Once 25% of your shares vest at year 1, you’ll receive $12,500 of taxable value, assuming your company stock price is the same as it was on your grant date.

It’s important to note that RSUs are considered taxable income when they vest. To minimize your RSU-related taxes, take a look at the top methods of reducing tax on RSU income.

As mentioned, the day an RSU vests, it generates ordinary income tax for the total dollar amount vested. If you sell these shares immediately, at the price they vested, you will not owe any additional tax. This is important!! Many people believe that if they sell shares immediately that they will incur short term capital gains. The vest price is your purchase price, which is why it generates ordinary income tax. So you’ve already been taxed on these shares!

Wondering if capital gains can push you into a higher tax bracket?

If your plan is to hold your shares for a period of time, holding for over 1 year from your vest date will allow you to pay long-term capital gains tax on any additional appreciation of your shares from the date of vest. By contrast, selling shares before 1 year from your vest date will incur short-term capital gains. Note that shares do not always go up and sometimes you end up vesting higher, and therefore paying income taxes on shares that are worth less at the time you sell.

What Are Stock Options?

Stock options are another well-known form of equity compensation, and are typically, but not always, reserved to pre-IPO companies or startups. In contrast to RSUs, these are essentially what they sound like–an opportunity (or option) to buy a preset number of shares of stock in your company at a predetermined price.

It’s important to note that stock options do not generate any taxable income at vest. Options are only taxable if exercised. This is notably different from RSUs, which generate taxable income at vest.

Because of this, some people prefer RSUs because the tax is essentially stretched out in smaller increments as shares vest. Options, on the other hand, only generate tax at exercise so if you waited for 5 years or more before you exercised all your shares, you could stand to have a very large income tax bill due all at once if the market value of your stock is well above the strike price.

There are numerous planning strategies around variable income structures like these that can be quite beneficial to your long-term financial plan and tax diversification strategy. In fact, it may even be beneficial that you can control when your stock based income is recognized. If you have questions regarding your stock, or if you just changed jobs and now have a new stock structure that you’re not familiar with, feel free to reach out.

Non-Qualified Stock Options (NQSO)

There are a few different subtypes of stock options you should familiarize yourself with. One of the two main stock option varieties is called non-qualified stock options, or “NQSOs.” With these options, you’ll recognize ordinary income and pay ordinary income tax on the difference between the grant price (or strike price) and the market value of the shares when you exercise your options.

An Example

Let’s say your employer granted you 10,000 shares through NQSOs at a strike price of $1 per share. There are no income taxes recognized when the grant is made. This is also true when these shares vest, if there is a vesting schedule.

Let’s assume that your company’s stock price shot up to $5 per share by the time the vesting period on your NQSOs has concluded. You’ll still be able to purchase these shares at the strike price of $1, meaning you’ll pay $10,000 to acquire all 10,000 shares. You’ll also have to pay income taxes on the $4 difference for each share at the time you exercise.

In summary, you’ll pay $10,000 to buy your shares. That generates $40,000 of taxable income to you. You can sell your shares immediately for $50,000.

Incentive Stock Options (ISO)

ISOs are similar to NQSOs, though there are two key differences to keep in mind. Specifically, ISOs are:

• Eligible for special tax treatment if you meet the holding period requirements.

• Not taxed when you exercise the stock, only when sold.

ISOs are not taxed when you exercise. In addition, gains are taxed at long-term capital gains rates as long as you hold the stock for:

• A) At least two years after the grant date; and

• B) At least one year after you exercised

If you don’t meet these requirements, you will disqualify the ISO which essentially switches its tax treatment to a NQSO.

It’s worth noting that ISOs come with an increased level of risk due to the holding period incentives before you can sell them at favorable tax rates. In addition, you might be able to do what’s called a cashless exercise which would automatically sell the amount of shares required to fund the purchase of your shares (so that you don’t have to come up with the cash yourself). This would create a partial disqualifying disposition but would also reduce the risk you’re taking by buying your shares.

Of course, you can also choose to sell early and disqualify the option. Money in hand today can be better than risking what the stock may do after the holding period is satisfied.

An Example

Due to the similarities between NQSOs and ISOs, the basics of the previous example will still hold true in this example. With ISOs, you’ll still be able to buy your 10,000 shares at the strike price of $1 and sell them at their market price of $5 when your options have vested.

This time, you will not recognize $40,000 of taxable income upon exercise (though you will still have to come up with $10,000 to buy your options). Assuming you adhere to the holding period outlined above, selling your shares for $50,000 would result in $40,000 of gains, which would be taxed as long-term capital gains instead of ordinary income.

Navigating Your Financial Future

These are the basic similarities and differences between RSU vs options. Though this should make it somewhat easier to make the most of your compensation, planning your financial future can still be a mind-bogglingly complicated task. That’s doubly true if you don’t have experience in the field.

If you’re a tech industry employee concerned about building a reliable financial plan for yourself, let Consilio Wealth Advisors help. Our team of experts knows exactly what steps current and former tech professionals should take at every stage of their lives. Set up an appointment with Consilio today to start building a foundation for your future.

Disclosures:

The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor.

The views expressed in this commentary are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward‐looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.

All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.