Stock Options at a Public Company: NSOs vs. ISOs and How They Are Taxed
The Quick Answer
Public companies grant two types of stock options: non-qualified stock options (NSOs) and incentive stock options (ISOs). NSOs are taxed as ordinary income when you exercise, based on the difference between the stock price and your exercise price. ISOs are not taxed for regular income tax purposes at exercise, but the spread can trigger the alternative minimum tax (AMT), and the best tax treatment only applies if you meet specific holding periods. Your state adds another layer: California, New York, and New Jersey tax gains as ordinary income, while Texas has no state income tax.
What types of stock options do public companies offer?
A stock option gives you the right to buy company shares at a fixed price, called the exercise or strike price, for a set period of time. If the stock rises above that price, the difference is your profit, often called the spread.
Non-qualified stock options (NSOs) are the most common type at public companies. They can be granted to employees, contractors, and board members, and they have no special tax treatment.
Incentive stock options (ISOs) can only be granted to employees. They qualify for more favorable tax treatment under the tax code, but they come with more rules: a maximum 10-year term, a $100,000 annual limit, based on grant-date value, on options that can first become exercisable each year, and a requirement to exercise within three months of leaving the company to keep ISO status.
Your grant agreement or equity portal (such as Fidelity, Schwab, or E*TRADE) will state which type you have. Some employees hold both.
How are NSOs taxed?
NSOs are taxed at two points: when you exercise and when you sell.
At grant and vesting: No tax. Receiving or vesting NSOs is not a taxable event at a public company.
At exercise: The spread (market price minus exercise price) is taxed as ordinary income. It appears on your W-2 and is subject to federal income tax, Social Security, Medicare, and state income tax. Your employer withholds federal tax at the supplemental rate, which is 22% on the first $1 million of supplemental wages and 37% above that. If your actual bracket is higher than 22%, you may owe more in April.
At sale: Any change in value after exercise is a capital gain or loss. Hold the shares more than one year after exercise for long-term capital gains rates; sell within a year and the gain is short-term, taxed as ordinary income.
Example: You exercise 1,000 NSOs with a $20 exercise price when the stock trades at $50.
Ordinary income at exercise: ($50 - $20) x 1,000 = $30,000
Your cost basis in the shares: $50 per share
You sell 18 months later at $60: ($60 - $50) x 1,000 = $10,000 long-term capital gain
Many people exercise and sell on the same day (a "cashless exercise"). In that case, there is little or no capital gain, and the full spread is ordinary income.
How are ISOs taxed?
ISOs can be taxed more favorably than NSOs, but only if you hold the shares long enough.
When you exercise: You usually owe no income tax. However, your paper gain can trigger the alternative minimum tax (AMT), a separate tax calculation that can create a bill even though you haven't sold anything.
When you sell:
Held long enough (more than 2 years from grant and 1 year from exercise): the entire gain is taxed at lower long-term capital gains rates.
Sold sooner: the spread at exercise is taxed as ordinary income, similar to NSOs, and any gain above that is a capital gain.
Example: You exercise 1,000 ISOs at $20 when the stock is at $50, then later sell at $60.
At exercise: no regular income tax, but possible AMT
Sold after meeting the holding periods: $40,000 long-term capital gain
Sold within a year: $30,000 ordinary income plus $10,000 short-term capital gain
Do state taxes affect stock options?
Yes. On top of federal tax, most states tax stock option income, and the rules vary. Some states tax all gains as ordinary income, a few have their own AMT, and states like Texas have no income tax at all. If you live and work in different states, such as New Jersey and New York, or you moved while your options were vesting, more than one state may tax part of the income.
Because state rules differ and change over time, check your situation with a licensed tax professional before exercising or selling.
Common Stock Option Mistakes
Double-counting income on NSO sales: Brokers often report your exercise price as the cost basis on Form 1099-B. Your true basis includes the income already taxed on your W-2. Without an adjustment, you pay tax twice on the same money.
Relying on 22% withholding: If you are in the 32%, 35%, or 37% bracket, withholding at 22% leaves a gap that shows up as a tax bill, and possibly an underpayment penalty.
Exercising ISOs without checking AMT: A large ISO exercise can create a tax bill on gains you have not realized. If the stock then falls, you can owe tax on value that no longer exists.
Letting options expire: Options that are in the money and expire unexercised are simply lost. Track expiration dates, especially after leaving a job.
Holding too much company stock: Keeping shares after exercise adds to the risk that your paycheck and your portfolio decline at the same time.
What should you do when you receive stock options?
Confirm the option type: Check your grant agreement or equity portal to see whether you hold NSOs, ISOs, or both.
Record the key dates: Note the grant date, vesting schedule, and expiration date for each grant.
Estimate the tax before you exercise: Model the ordinary income for NSOs and the AMT impact for ISOs, including state tax.
Plan for withholding gaps: Set aside cash or make estimated tax payments if 22% withholding will fall short.
Decide how much company stock to keep: Set a target for how much of your net worth you are comfortable holding in one company.
Keep your tax forms: Save Forms W-2, 3921, and 1099-B, and make sure your cost basis is reported correctly when you sell.
Frequently Asked Questions (FAQs)
Do I pay tax when my stock options vest? No. At a public company, vesting stock options is not a taxable event. Tax applies when you exercise and when you sell.
Are ISOs always better than NSOs? Not always. ISOs can produce lower taxes if you meet the holding periods, but they carry AMT risk and require holding the stock, which increases concentration risk.
What happens to my stock options if I leave my job? Vested options usually must be exercised within a set window, often 90 days. ISOs not exercised within three months of leaving lose ISO status and become NSOs. Unvested options are typically forfeited.
Can I avoid AMT on ISOs? You can often reduce it by exercising in smaller amounts across multiple years, or by exercising and selling in the same calendar year, which removes the AMT adjustment but results in ordinary income.
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About the author
Michael Walstedt, CFA, CFP®, is the founder of Reliant Wealth Advisory, a fee-only fiduciary firm in Hoboken, New Jersey. He helps tech professionals in the New York/New Jersey area, as well as nationwide, plan around stock options, RSUs, and concentrated stock positions.
This article is for educational purposes only and is not tax, legal, or investment advice. Tax rules change, and your situation may differ. Consult a qualified tax professional before acting.
