Equity Compensation: RSUs, ISOs, and ESPPs Explained

For many tech and startup employees, equity makes up a third or more of their compensation — yet most people treat it like a lottery ticket instead of an asset to manage. Understanding how your equity is taxed is the difference between keeping most of it and handing a surprise share to the IRS.

The Three Common Vehicles

• RSUs (restricted stock units) — you're promised shares that vest over time. The moment they vest, the full market value is taxed as ordinary income (subject to withholding). After that, they're just stock: any further gain or loss is capital gains.
• ISOs (incentive stock options) — you get the right to buy shares at a set price. If you meet the holding requirements (held 2 years from grant and 1 year from exercise), the gain is taxed at long-term capital gains rates. The complication is the Alternative Minimum Tax (AMT): the spread at exercise can trigger AMT even though you haven't sold anything.
• ESPPs (employee stock purchase plans) — you buy company stock at a discount (often 15%) through payroll deductions. If you hold long enough, that discount can qualify for favorable tax treatment.

The Tax Mechanics That Matter

RSUs are the simplest — and the most misjudged. Because RSUs are taxed as income at vesting, many companies withhold shares to cover the tax. The "sell immediately" strategy — liquidate at vest and redeploy the cash into a diversified portfolio — is the default recommendation for a reason: there's no tax advantage to holding, and holding concentrates your human and financial capital in one company.

ISOs carry a timing trap. The smart move is often to exercise early (when the spread — and thus the AMT hit — is small) and hold for the long-term capital gains qualification. But "exercise and hold" ties up cash (to buy the shares and pay AMT), which is a risk if the stock later falls.

The 0.9% additional Medicare tax applies to compensation income above $200,000 (single) / $250,000 (married), so large RSU vests in a high-income year also get hit with that surcharge.

The Bigger Risk: Concentration

Tax is only half the story. The other half is concentration. A software engineer whose salary and equity are both tied to one company is doubly exposed: if the company stumbles, the job and the stock drop together. The standard advice — regardless of tax optimization — is to sell enough equity to keep any single company at a small share (many use 10–15%) of your total portfolio.

Strategies That Actually Help

• Sell RSUs at vest. Treat them like cash compensation. No tax benefit to holding.
• Coordinate vesting with low-income years. If you expect a lower-income year (sabbatical, job change), timing a sale can land gains in a lower bracket.
• Plan for AMT with ISOs. Run the numbers with a tax pro before exercising a large grant — the AMT bill can be five figures even when you haven't sold.
• Use the tax-loss harvest. If company stock you've held drops, harvest the loss to offset other gains.
• Don't let the tax tail wag the dog. Deferring a sale to get long-term rates while the stock doubles its concentration risk is usually a bad trade.

Related Reading

• Capital Gains Tax — Short-term vs. long-term on your equity sales
• How Tax Brackets Actually Work — Where vesting income lands
• Diversification — Why concentrated positions are risky
• Understanding Your Paycheck — How equity shows up alongside salary