How is equity taxed? A clear guide to RSUs, ISOs, NSOs, and ESPP

How is equity taxed? A clear guide to RSUs, ISOs, NSOs, and ESPP

For high-income professionals, equity compensation can be an incredible asset—but managing its tax implications can be overwhelming. Restricted Stock Units (RSUs), Stock Options (ISOs and NSOs), and Employee Stock Purchase Plans (ESPPs) all come with their own sets of rules, intricacies, and opportunities for tax planning.

This Range blog is designed to help you confidently understand how each type of equity is taxed and equip you with actionable insights to make informed financial decisions.

Understanding RSUs (Restricted Stock Units)

Restricted Stock Units, or RSUs, are a popular form of compensation for high-earning employees at large firms and well-funded startups, especially those valued over $1 billion. RSUs are as straightforward as equity gets—you’re granted shares that become yours after they vest. No purchase required.

Key features of RSUs:

• Vesting occurs over time or upon reaching specific milestones.
• Once vested, you own real company stock.
• A portion of shares is withheld for taxes at vesting, and the remaining shares appear in your brokerage account.

RSU taxation

RSU taxation happens in two stages:

1. At Vesting

• The fair market value of your RSUs at vesting is treated as ordinary income and appears on your W-2.

Example:

• 300 RSUs vest at $50/share.
• $15,000 is added to your taxable income.
• Employers withhold taxes by keeping back a percentage of your shares.

2. At Sale

• When you sell the shares, the gain or loss compared to the vesting price is taxed as a capital gain or loss:
• If held 1 year or less from vesting, it’s considered short-term capital gains (taxed at ordinary income rates).
• If held more than 1 year, it qualifies for long-term capital gains (lower tax rates).

Insight: RSUs are inherently simpler than other forms of equity, but timing your sales strategically can make a significant difference in your tax outcome.

Understanding stock options

Stock options are agreements that allow employees to buy company shares at a fixed price (the “strike price”). This gives employees an incentive to help the company grow, increasing the value of their shares.

There are two primary types of stock options:

Incentive Stock Options (ISOs)

• Offer favorable tax treatment but come with strict holding requirements.

Non-Qualified Stock Options (NSOs)

• Simpler and available to more employees but lack the beneficial tax treatment of ISOs.

Most options follow a vesting schedule, such as four years with a one-year cliff (you earn 25% of shares in the first year, then the rest monthly or quarterly over three years).

ISO taxation

1. At Exercise

No regular taxes are due, but exercising can trigger the Alternative Minimum Tax (AMT) if the spread (difference between exercise and market price) is large.

2. At Sale

Qualifying Disposition: Shares must be held for two-plus years from the grant date and one-plus year from the exercise date, and the entire gain is taxed at the lower long-term capital gains rate.

Example:

• Grant price = $10/share. You sell at $80/share after qualifying.
• $70/share gain is taxed as long-term capital gains.

Disqualifying Disposition: If sold too soon, the gain is taxed partly as ordinary income and partly as capital gains.

Pro Tip: ISOs are powerful tools for tax efficiency but can get complicated. Planning with a financial advisor is essential to avoid costly AMT surprises.

NSO taxation

For NSOs, taxation is simpler:

• At exercise, the spread (market price - strike price) is treated as ordinary income and reported on your W-2.
• At sale, any gain/loss from when you exercised is taxed as capital gains, with rates depending on your holding period.

Example:

• Exercise at $20/share with a market price of $50/share = $30/share taxed as ordinary income.
• Later sell at $70/share = $20/share taxed as capital gains.

Takeaway: With NSOs, understanding the tax hit at exercise is critical for making smart decisions about how many options to exercise and when.

Understanding Employee Stock Purchase Plans (ESPPs)

An ESPP is perhaps the easiest way to invest in your company’s stock. These plans allow employees to buy shares at a discount, often 10%-15%, using payroll deductions.

Key features of ESPPs

• Contributions are post-tax (up to $25,000 annually).
• Typically includes a “look-back” provision, meaning the discount applies to the lower price at the start or end of the offering period.

Example:

• Stock price at the start = $10.
• Stock price at purchase = $15.
• You pay $8.50/share (15% discount on $10), with shares immediately worth $15.

ESPP taxation

Like ISOs, ESPP tax treatment depends on how long you hold the shares:

1. At Purchase

• No tax is owed when shares are purchased—this is a common misconception.

2. At Sale

Qualifying Disposition: Hold shares two-plus years from offering date and one-plus year from purchase.

• Discount portion taxed as ordinary income, remainder taxed as long-term capital gains.

Disqualifying Disposition: If sold earlier, the discount is fully taxed as compensation income on your W-2, and additional gains are taxed as capital gains.

Example of a Qualifying Disposition:

• Offering price = $10/share. Purchase with look-back + discount = $8.50/share.
• Sell at $18/share after holding period =
• $1.50/share (discount from look-back price) taxed as ordinary income.
• $9.50/share taxed as long-term capital gain.

Pro Tip: To maximize ESPP benefits, aim for qualifying dispositions whenever possible for the most favorable tax treatment.

Why understanding equity taxation matters

Equity compensation can create life-changing financial opportunities—but failing to understand how it's taxed can lead to costly surprises. RSUs, ISOs, NSOs, and ESPPs each have unique rules and planning strategies that, when managed properly, can help you achieve your financial goals more efficiently.

This story was produced by Range and reviewed and distributed by Stacker.