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Equity compensation can take different forms, so it’s important to know the difference between stock grants and stock options. Stock grants give you shares up front, while stock options let you buy shares at a set price in the future. This difference affects how they’re taxed and the level of risk involved.
A financial advisor can offer you specific insights on stock portfolios and purchasing strategies that could align with your long-term goals.
How Stock Grants Work
Stock grants give employees actual shares of company stock. The ownership is immediate, but often comes with a vesting period. These grants are designed to attract and retain talent while aligning employee interests with company performance. The value of stock grants is tied directly to the company’s market performance. If the company does well, so do these employee shareholders.
Stock grants commonly come in two forms: restricted stock units (RSUs) and restricted stock awards (RSAs). RSUs represent a promise to deliver shares after vesting. RSAs grant actual shares upfront, with restrictions that lift during vesting. RSUs have become more popular because they simplify administration and offer more predictable tax treatment. Once vested, employees have full ownership of their shares. They can decide whether to hold them in their investment portfolios or sell them for cash.
How Stock Options Work
Stock options let employees purchase company shares at a predetermined rate, called a strike price or exercise price. Unlike grants, options require the employee to take action to acquire shares after a vesting period. When a company offers stock options, they’re essentially providing the opportunity—but not the obligation—to buy shares at today’s price, even if the stock value increases in the future.
Most stock options come with vesting schedules, commonly spanning four years with a one-year cliff. This means employees must remain with the company for at least one year before any options vest, with the remainder vesting monthly or quarterly. The exercise (or strike) price is set when options are granted, usually at the fair market value of the stock on that date.
Companies typically offer either Incentive Stock Options (ISOs) or Non-qualified Stock Options (NSOs). ISOs provide potential tax advantages but have stricter requirements, while NSOs are more flexible but don’t offer the same tax benefits. When exercising stock options, employees pay the strike price to purchase actual shares. Unlike stock grants, options come with an expiration date (often up to 10 years).
Pros and Cons of Stock Options and Grants
Understanding the differences between stock grants vs. stock options becomes crucial for making informed financial decisions. Each comes with distinct advantages and disadvantages that can impact your financial future.
- Potential for significant upside: Stock options allow employees to benefit from company growth without initial investment. If the company’s share price rises substantially above your strike price, you could realize considerable gains upon exercising your options.
- Tax flexibility: With options, you generally don’t incur tax liability until you exercise them. This gives you control over when to trigger taxable events, potentially allowing for better tax planning strategies.
- Motivation for company performance: Options create a direct link between your financial reward and the company’s stock performance. This alignment of interests can be highly motivating, especially in growth-stage companies where significant value creation is possible.
- Expiration risk: Unlike grants, options have expiration dates. If the stock price doesn’t exceed your strike price before expiration, your options could become worthless.
- Exercise costs: You must pay the strike price to purchase shares when exercising options. This upfront cost can be substantial and might require significant capital at exercise time.
- Complex tax implications: Depending on the type of options (ISOs vs. NSOs), you may face alternative minimum tax considerations or ordinary income tax on exercise. These complexities often necessitate professional advice from a tax consultant.
- Immediate value: Stock grants provide value regardless of future stock performance. Even if the company’s share price declines after your grant date, you still own something of value.
- Simplicity: Grants are straightforward—you receive shares directly without needing to make purchase decisions or calculate optimal exercise timing.
- No expiration concerns: Once vested, granted shares are yours to keep indefinitely, eliminating the pressure of expiration dates that come with options.
- Immediate tax consequences: Stock grants typically trigger tax liability upon vesting. This means you might owe taxes before you’ve sold any shares or realized cash gains.
- Limited upside compared to options: While grants provide guaranteed value, they offer less leverage than options. The same dollar value of options could potentially yield much higher returns in a rapidly growing company.
- Less flexibility: With grants, you generally can’t control the timing of taxation as you might with options, potentially resulting in suboptimal tax situations.
Tax Implications of Equity Compensation
The timing of taxation represents one of the most significant differences between equity compensation types. With restricted stock unit (RSUs) taxes, you’ll pay as soon as they vest and become yours. In contrast, with stock options, you control when the tax event occurs by choosing when to exercise. This timing flexibility can be valuable for tax planning, allowing you to potentially coordinate exercises with lower-income years.
The type of tax you’ll pay on equity compensation varies based on several factors. Initial taxation typically occurs at ordinary income tax rates, which can reach up to 37% in federal tax brackets, plus state taxes. However, if you hold shares after acquiring them, any subsequent appreciation may qualify for lower long-term capital gains rates (currently maxing at 20%) if you meet the holding period requirements of at least one year.
Bottom Line
Understanding the differences between stock grants and stock options is essential for employees considering equity compensation. Stock grants offer immediate ownership with less risk, providing value even if the stock price doesn’t increase, though they come with immediate tax implications. Stock options, while potentially more lucrative if the company’s value rises significantly, carry greater risk and complexity with their exercise requirements and expiration dates.
Investment Planning Tips
- A financial advisor can help you evaluate investments and manage risk for your portfolio. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- If you want to diversify your portfolio, here’s a roundup of 13 investments to consider.
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