How are Stock Options Taxed?

Exercising your stock options can feel like a windfall—until the tax bill hits. Stock options can be a fantastic way to build wealth, particularly when working for a fast-growing company, but many employees fail to fully understand how their options will be taxed when they pull the trigger. Whether you’re holding ISOs or NSOs, understanding the tax implications of that critical moment can save you thousands—or cost you dearly if you’re unprepared.

In this guide, we’ll break down what happens tax-wise when you exercise your stock options, from the immediate hit to your wallet to the long-term gains you might score. Stick around for real-world examples and tips to minimize your tax burden.

How Are Stock Options Taxed?

Incentive Stock Options (ISOs):

When you exercise ISOs, you don’t owe regular income tax—yet. Instead, the spread (409A fair market value minus strike price) gets factored into the Alternative Minimum Tax (AMT) calculation. For example, if you exercise 1,000 ISOs at $10 each when the stock’s worth $50, that $40,000 spread could push you into AMT territory.

When you eventually sell the shares, you’ll pay capital gains tax—long-term rates (0-20%) if you hold them at least one year post-exercise and two years post-grant, or short-term rates (ordinary income) if you sell sooner. The tax is paid based on the difference between your sale price and strike price. Let's say you sell those same 1,000 shares at $100 per share, you would be taxed via either short or long term capital gains on your $90,000 of gain.

At first glance, it might feel like you’re getting double-taxed on that initial spread at exercise with ISOs—paying AMT on top of potential future taxes. But here’s the good news: the AMT you shell out can often be reclaimed later through AMT credits. Curious how that works? Check out our deep dive on AMT credits to see how you can turn that tax hit into a future win.

Tip: Exercise early in the year to gauge your AMT exposure and adjust other income if needed—something the IRS won’t tell you upfront. Check out ESO's AMT Calculator for an estimate.

Non-Qualified Stock Options (NSOs):

NSOs hit you with ordinary income tax on the spread at exercise, reported on your W-2. Say you exercise 1,000 NSOs at $10 when the 409A is $50: that $40,000 spread is taxed at your income rate—could be 37% if you’re in a high bracket. Plus, your employer withholds taxes at the time of exercise, so that money is due upfront on top on the exercise cost.

When you sell the shares later, the gain from exercise price to sale price is taxed as capital gains—long-term if held over a year, short-term if not, but unlike ISOs, NSOs are taxed at sale based on your sale price minus the FMV you paid taxes on at exercise. For example, sell those same 1,000 shares at $100 per share, and the the $50,000 gain is taxed as either short or long term capital gains, depending on how long you held them.

Tip: Check your cash flow before exercising—those taxes are due immediately, not at year-end.

RSUs:

Restricted Stock Units (RSUs) aren’t technically stock options—check out our RSUs vs. Stock Options breakdown for the full scoop—but they’re a popular form of employee equity, especially at late-stage private companies. Unlike options, RSUs don’t require you to exercise them. Instead, they’re taxed either when they vest or, more often, at liquidity under a 'double-trigger' setup. The two triggers? (1) The RSUs vest over time, and (2) the company goes public or gets acquired, making the shares liquid. So, if you’re holding RSUs, you’ll owe taxes on the vested amount once that liquidity hits—based on the fair market value at that time—even if you’re not planning to sell.

‍Tip: Brace for a tax bill you can’t cash out unless you sell some shares.

Sale After Exercise:

Once you exercise and hold the shares, selling them later triggers capital gains tax. For ISOs, hold at least one year post-exercise and two years post-grant to qualify for long-term rates. NSOs? The clock starts at exercise, and short-term gains (under a year) get taxed as ordinary income. Here’s a quick comparison:

State Taxes:

State taxes pile on when you exercise NSOs, since the spread is income. California’s 13.3% top rate could sting, while Texas and Washington (0% income tax) let you off easier. ISOs dodge state tax at exercise unless AMT triggers a state adjustment.

‍Tip: Live in a high-tax state? Consider exercising NSOs in chunks over multiple years to stay in a lower bracket—check your state’s rules, as they vary.

Common Pitfalls When Exercising

Next Steps After Exercising

Exercised your options? Now you’ve got shares—but with private stock, selling isn’t always an option unless a tender offer or secondary sale comes up. Your next move is to decide: hold for potential long-term gains if liquidity hits, or plan for the right moment to cash in when available. Keep tight records of your basis (exercise price + taxed spread)—messy tracking means tax trouble down the line.

Worried about covering the exercise and tax costs? ESO Fund can step in to bridge the gap, so you’re not stuck footing a bill you can’t swing. Contact us via the form below for a tailored take on your exercise game plan.