Equity compensation can be the most valuable or the most overhyped part of a job offer, depending on the company and the terms. Restricted stock, options, and employee stock purchase plans work in very different ways and carry different risks and tax treatment. Learning the mechanics helps you judge what an equity grant is really worth.
Vesting schedules and the cliff
Equity is almost never yours all at once; it vests over time to encourage you to stay. A common schedule is four years with a one-year cliff, meaning you must work a full year before the first quarter of the grant vests, then the rest vests in monthly or quarterly increments. If you leave before the cliff, you typically forfeit the unvested equity entirely. Understanding the schedule tells you how long you must stay to realize the promised value.
Restricted stock units
Restricted stock units, or RSUs, are the simplest form: they become actual shares as they vest. At vesting, the value of the shares is taxed as ordinary income, just like salary, and employers often withhold shares to cover it. After vesting, any further change in the share price is a capital gain or loss when you sell. Because RSUs have value as long as the stock is worth anything, they are generally less risky than options.
Stock options and strike price
Options give you the right to buy shares at a fixed strike price, so they are only valuable if the stock rises above that price. Non-qualified options are taxed as ordinary income on the spread between strike and market price when you exercise. Incentive stock options can receive favorable capital-gains treatment if holding rules are met, but may trigger the alternative minimum tax. If the share price never exceeds the strike price, the options are worthless, which is the key risk.
Employee stock purchase plans
An employee stock purchase plan, or ESPP, lets you buy company stock at a discount, often up to 15 percent, through payroll deductions. Many plans include a lookback that prices the purchase from the lower of the start or end of the offering period, boosting the effective discount. The discount is generally taxed, with the split between ordinary income and capital gains depending on how long you hold the shares. A well-designed ESPP can be a low-risk benefit, especially if you sell soon after purchase.
Sam is granted 400 RSUs vesting over four years with a one-year cliff, and the stock trades at $50. After year one, 100 shares vest and $5,000 is taxed as ordinary income at that value. If Sam holds the shares and they rise to $70 before selling, the extra $20 per share is a capital gain.
Key takeaways
- Equity vests over time, commonly four years with a one-year cliff.
- RSUs are taxed as ordinary income at vesting, then as capital gains when sold.
- Options only pay off above the strike price and can be worthless if the stock stays low.
- ESPPs offer a discount, often 15 percent, and can be low-risk if sold promptly.
Common mistakes
- Treating a large equity grant as guaranteed cash before it vests.
- Confusing options, which can expire worthless, with RSUs, which retain value.
- Overlooking the tax owed at vesting or exercise and getting caught short at filing.
FAQ
When are RSUs taxed?
RSUs are taxed as ordinary income when they vest, based on the share value at that moment, and again as capital gains or losses when you later sell.
What makes stock options riskier than RSUs?
Options only have value if the stock price exceeds the strike price, so they can expire worthless, whereas RSUs keep value as long as the stock is worth anything.