Understanding How the Stock Options Tax Works

For many employees in America, especially those at tech companies and other startups, stock options are a part of compensation packages. While the right to buy stock in a company at a set price is an attractive form of compensation, stock options have more complex tax implications than straight cash. Many taxpayers will use a financial advisor to help them develop the best tax strategy for their investments. Let’s take a look at how your tax return will change depending on whether you have incentive stock options (ISOs) or non-qualified stock options (NQSOs).

Types of Stock Options

The two basic types of stock options are non-qualified stock options (NQSOs) and incentive stock options (ISOs). While both are non-traditional forms of compensation, the two types of stock options work differently.

Incentive stock options are typically offered to employees and receive favorable tax treatment if certain requirements are met. When you exercise ISOs, you generally don’t owe regular income tax right away, though the spread between the exercise price and the market value may trigger the alternative minimum tax. If you hold the shares long enough after exercise and sale, any profit is usually taxed at long-term capital gains rates rather than ordinary income rates.

Nonqualified stock options are more common and can be granted to employees, contractors or board members. When you exercise NSOs, the difference between the exercise price and the stock’s fair market value is taxed as ordinary income and subject to payroll taxes. Any additional gain or loss after you hold and sell the shares is then taxed as a capital gain or loss.

The tax treatment of stock options can also vary depending on whether the recipient is an employee or a non-employee. Employees may see taxes withheld automatically when NSOs are exercised, while non-employees often need to plan for estimated tax payments. These distinctions can affect cash flow and the timing of tax obligations.

Stock options in public companies are generally easier to value and sell, which can simplify tax planning. Private company options can be more complex, since limited liquidity and uncertain valuations may delay when taxes are triggered or when gains can be realized. This can make understanding the rules around exercise and sale especially important.

Taxes for Non-Qualified Stock Options

Exercising your non-qualified stock options triggers a tax.

Non-qualified stock options (NSOs) are taxed when you exercise them, not when they’re granted. At exercise, the difference between the exercise price and the stock’s fair market value is treated as ordinary income and reported on your W-2 or 1099, depending on your employment status. Because the spread is considered compensation, it’s subject to federal and state income taxes as well as payroll taxes like Social Security and Medicare. Employers often withhold some of these taxes automatically for employees, but the withholding may not fully cover the total tax owed.

Once you own the shares, any additional change in value is taxed when you sell them. If you hold the stock for more than one year after exercise, gains or losses are taxed at long-term capital gains rates; shorter holding periods result in short-term capital gains taxed as ordinary income. The timing of exercise and sale can significantly affect your overall tax bill. Exercising when the stock price is lower or planning sales around your income level can help manage taxes, making strategic planning especially important.

Taxes for Incentive Stock Options

Incentive stock options, on the other hand, are much more tax-friendly for employees. If you receive ISOs as part of your compensation, you won’t have to pay any tax on the difference between the grant price and the price at the time of exercise. You don’t even have to report them as income when you receive the grant or exercise the option.

You will still have to pay tax on the money you make from selling the actual stock units though. The long-term capital gains tax applies to sales made two years after the grant and one year after exercising the option. The regular income tax applies to earlier sales.

Don’t forget about the alternative minimum tax. Those with a lot of tax-free income could be subject to this tax, so it’s important to be mindful of these rules or get the help of a financial advisor.

When to Exercise Stock Options

You can only exercise stock options after they vest, which typically happens over time or after specific milestones are met. Knowing your vesting timeline helps you avoid exercising too early or missing opportunities if you leave the company. Here are four times when you may choose to exercise your stock options:

Changing jobs: You might exercise your stock options when leaving a company. At that moment, your employer will offer you a post-termination exercise (PTE) period, or a limited timeframe of up to three months to exercise your options.
Early exercise: Usually, options vest gradually over a period of time. But some employees can buy company stock right after accepting an option grant. Taking an early exercise means that you can also benefit from paying less taxes on gains. You will need to file tax form 83(b).
Initial public offering (IPO): When company shares are taken public, you can exercise and sell your stock on the market. But keep in mind that if you do not hold on to your stock for at least one year, your gains will be taxed at a higher rate as ordinary income.
Company acquisition: If your company gets acquired, your stock options may be compensated or converted into shares of the acquiring company. You might be able to exercise your options during or after the acquisition deal.

Bottom Line

Investors will pay income tax or capital gains tax when they sell shares on the open market.

How you’ll pay taxes on stock options largely depends on whether you receive NQSOs or ISOs. Either way, you’ll pay income tax or capital gains tax when you sell the shares on the open market. With NQSOs, you’ll also pay income tax on the difference between the share value and your grant price when you actually exercise the option. With ISOs, you won’t have to pay income tax when you exercise the stock option. This makes them more attractive out of the two, but also explains why they’re generally reserved for high-ranking officers in a company.

Tax Tips

Even if you’re not receiving stock options, you may want to work with a financial advisor to optimize your taxes for investments. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Knowing how much you’re likely to pay in income taxes is important for planning your financial life. Find out how much you’ll likely owe with SmartAsset’s free income tax calculator.
There are many different tax planning strategies to lower your taxes. A financial advisor could help you use tax-loss harvesting to bring down your taxes on any capital gains made during the year.