There's a reason jobs at promising startups are often in high demand: The stock options could make you rich — though they can just as easily end up worthless if the company never goes public or the stock price falls. We've all heard the splashy stories about the overnight millionaires created when tech giants go public, like the recent SpaceX example, but for every success story there are many options grants that never pay off.
But taxes on those stock options can be complicated, and getting it wrong can have consequences — like the kind with a lot of zeros on the end. Understanding how options are taxed could help you avoid costly mistakes.
How your stock options are taxed
How your employee stock options are taxed depends on the type of stock option you have.
- Nonqualified stock options (NSOs) are stock options that companies can issue to both employees and non-employees. NSOs are often taxed at a higher rate than incentive stock options. But their tax treatment is pretty straightforward: You pay ordinary income tax when you exercise the options and capital gains tax if you sell the shares for a profit.
- Incentive stock options (ISOs) are stock options that companies issue only to employees. They enjoy several tax benefits, but that tends to make them complicated. In particular, ISOs aren’t taxed when they’re exercised. Instead, you pay tax when you sell your shares. If you meet the holding-time requirements, you may pay long-term capital gains tax rates instead of potentially less favorable short-term capital gains tax rates.
Good to know:
- This article discusses federal income and capital gains taxes, but you may also need to consider state income and capital gains taxes, which vary widely. California, for example, has no favorable capital gains rate at the state level, so all gains on shares are taxed as ordinary income.
- Net investment income tax, which adds 3.8% to some or all of your capital gains, may also be a factor if your modified adjusted gross income is more than $200,000 (single filer) or $250,000 (married filing jointly). It’s worth looking into especially if the income from your options would push you above the threshold for the first time.
How that actually works
Here’s a scenario to illustrate stock option taxes, including the differences in how NSOs and ISOs are treated.
- Your company grants you 2,000 stock options at the time you join. The options have a $5 strike price. It’ll cost you $10,000 to exercise.
- You decide to exercise all the options at once, when the company shares are valued at $20. That makes the bargain element (that is, the difference between the market value of the shares and the below-market price you’re paying) $15 per share, or $30,000.
- When you decide to sell your shares, their value has increased to $25 per share. That’s a capital gain of $5 per share, or $10,000.
- For this example, let’s say your household earnings put you in the 24% federal tax bracket and the 15% capital gains tax rate.
Here’s generally how your shares would be taxed.
NSOs | ISOs | |
|---|---|---|
When they’re granted | Not taxed. | Not taxed. |
When they’re exercised | You may owe ordinary income taxes on the bargain element.
| Ordinary income taxes are deferred. But the bargain element might trigger alternative minimum tax (AMT). |
When they’re sold | Any profit you make when selling your shares is subject to capital gains tax. Whether you pay short- or long-term capital gains tax rates depends on how long you own the shares. (We’ll assume you held the shares for at least a year.)
| If you meet certain holding period requirements when you sell, any profit from the sale may be taxed at long-term capital gains tax rates, which are usually lower than ordinary income tax rates. To get the favorable tax treatment, you’d have to hold the shares for at least a year after the exercise date and at least two years after the grant date.
If you don’t meet holding requirements, the bargain element is taxed as ordinary income and any gains are taxed as capital gains. You’d pay the same taxes as if you held NSOs. |
Total tax paid | $8,700 | $6,000 |
How to get ahead of your tax bill
Understanding stock option taxes is one thing. Knowing how to navigate them strategically takes careful planning, and maybe some expert help. If you’re working out a plan for your stock options, consider working with a financial advisor or tax professional with expertise in employee equity. (Note: "financial advisor" is a general term that isn't regulated — anyone can use it regardless of credentials — so it's worth verifying a prospective advisor's specific registration and certifications, such as through FINRA BrokerCheck or the SEC's IAPD database.) That person could help you think through the timing, risks and benefits relevant to your unique financial situation.
“NSOs are inherently simple. There’s no choice apart from the choice of when to exercise,” says James Bashall, a certified financial planner (CFP®) and CPA with NerdWallet Wealth Partners, an investment adviser affiliated with NerdWallet. “With ISOs, there’s so much more strategy involved. That’s where the advisor becomes important.”
1. Understand what you hold
You might hold both ISOs and NSOs. Both can be granted to employees. But there are also a couple of instances when your ISOs could turn into NSOs instead.
- The $100K rule: The IRS limits the amount of ISOs that employers can grant to each employee in a single calendar year. If the fair market value of the stock exceeds $100,000, the options above the limit are treated as NSOs.
- Leaving the company: If you separate from your employer but have vested ISOs, you typically have up to three months to exercise them to maintain their ISO status. After this time, your ISOs convert into NSOs.
Your tax planning will be shaped around the type(s) of stock options you hold. And if you have both, you have a different set of strategies at your disposal than if you hold only one type. For example, when you exercise NSOs, your ordinary income taxes may be uncharacteristically high that year. That could give you an opportunity to exercise ISOs without triggering alternative minimum tax. More on this below.
2. Plan for AMT
The possibility of triggering alternative minimum tax (AMT) is what makes ISOs more complex than NSOs. AMT is a tax system that runs parallel to the standard tax system. It has different tax rates that are intended to ensure certain high-earning taxpayers pay at least a minimum level of income tax. Their income taxes are calculated under regular tax rules and under AMT rules, and they owe whichever resulting tax bill is higher.
When you exercise stock options, the discount you receive — also called the bargain element — is counted as income in the eyes of the IRS. With ISOs, the tax owed on that income is deferred under the standard tax system until you sell your shares. Then the tax treatment is determined by whether you met the holding period requirements.
Under the AMT system, it works differently. In the year you exercise ISOs, the extra income may be large enough that you could owe AMT before you’ve sold a single share.
There are a number of strategies for navigating AMT and preventing surprises. The right strategy depends on your specific income (all of it, not just from your options), as well as the type and number of options you hold.
For example, Bashall says, you could calculate how many shares you can exercise in the year without incurring AMT. That may mean you exercise your options in batches over the course of several years — or exercise a larger share of ISOs in a year when your ordinary income is unusually high (e.g., you’ve exercised NSOs, received vested restricted stock units (RSUs) or some other big bonus). Ordinary income is counted under both tax systems, but tax rates are highest in the standard tax system, which can make your regular tax bill climb faster than the potential AMT bill. With a wider gap between the two, you may have more room to exercise ISOs without triggering AMT.
Learn more ISO strategies
What about NSOs?
AMT isn’t relevant for NSOs, because taxes on NSOs are not deferred at exercise. That means your major tax event happens when you exercise. At that point, your employer usually will withhold the required taxes. They may offer you the choice of paying those taxes in cash or reducing the number of company shares you receive to cover the taxes due. You’ll still need to check whether the amount your employer withholds is enough to cover the taxes you’ll actually owe — and make a plan to pay the difference if it doesn’t — but you won’t have to contend with a secondary AMT system.
3. Use time to your advantage
Since taxes aren’t due on your ISOs until you sell the shares, your employer does not need to withhold taxes on your behalf. If exercising your options triggers a tax bill — AMT or otherwise — you may need to come up with a hefty sum of cash. Generally, your choices are paying those taxes out of pocket or using the proceeds from selling some of your stock (if that option is available). If you decide to sell, there are some strategies that could allow you to cover your tax bill without giving up better tax treatment for ISOs.
For example, if you exercise ISOs early in a calendar year, you could hold them for a year to meet holding requirements (this is called a qualifying sale) and still have time to sell some to pay your tax bill before it’s due the following April, says Steve Moyer, a certified financial planner and certified equity professional with Mariner, a wealth management firm. This is one reason to carefully consider when to exercise your options.
Exercising early in the year also gives you more flexibility, Moyer says. Before the end of the calendar year, you can assess the price and determine if it makes better sense to continue holding the shares until they’re a qualifying sale or to sell them (known as a disqualifying sale). “If the price is down substantially, we just disqualify, pay less tax and kind of move on from it that way,” Moyer says. “It gives us more control.”
Using time to your advantage becomes even more important if you hold options in a private company that’s planning an IPO. You may decide to exercise options before your employer goes public, when the market value of the shares may be lower, allowing you to start the clock toward better capital gains tax treatment. But you’ll also have to navigate your company’s lockup agreement (which could prevent you from selling shares for several months after the stock starts trading).
4. Consider your risk tolerance
You may pay less tax if you hold your ISOs for at least a year after the exercise date and for at least two years after the grant date. But holding your shares isn’t always the best strategy, and avoiding taxes isn’t always the best goal, Bashall says.
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Instead, your decision should also take into account the risks of holding your shares long-term. Consider two common risks you’ll face with stock options after you exercise.
Risk of lost value: If the company stock price drops below what you paid (the strike price), you could lose money. “Potentially exercising options and immediately selling [the shares] — you’re locking in the gain instead of running the risk of it turning into a loss over the next 12 months,” Bashall says.
If you don’t need the money, you may determine you can tolerate this risk. But if you’re planning to use it to achieve a financial goal, such as buying a home or reaching financial independence, you may decide that paying higher capital gains taxes is better than the alternative.
Concentrated exposure: If too much of your wealth is tied to the performance of your employer, which also pays you wages, any struggles it has could have an outsized impact on your finances. Many financial advisors generally encourage investors to reduce their concentrated stock risk by selling shares and diversifying their portfolios, though the right approach depends on your individual circumstances and risk tolerance.
That doesn’t mean you have to sell everything at once. But selling enough to cover your tax bill, for example, could also serve as a way to avoid a concentrated exposure to a single stock.
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- 1.IRS. Publication 15-B, Employer's Tax Guide to Fringe Benefits. Accessed Aug 18, 2026.
- 2.National Archive Code of Federal Regulations. § 1.423-1. Accessed Aug 18, 2026.
