Do You Pay Tax When You Exercise Stock Options? ISOs vs NSOs for High-Income Families

By Kevin Luu, Co-Founder and Chief Learning Officer. Reviewed on 2026-09-30.

It depends on the type of option. With nonqualified stock options (NSOs), yes: the spread between the stock’s value and your strike price is taxed as wages in the year you exercise, at your full federal and state income tax rates plus Medicare tax. With incentive stock options (ISOs), you owe no regular income tax at exercise, but the same spread counts toward the alternative minimum tax (AMT), which can produce a large bill for a high-income household even though you sold nothing.

For a two-earner family in the Bay Area or Seattle with $750,000 to $3 million of W-2 income, the difference between the two is often six figures on a single exercise. This guide shows how each type is taxed, with worked numbers at that income level, and the decisions you actually need to make before you click “exercise”.

NSOs vs ISOs: what is taxed, and when

The IRS calls ISOs and employee stock purchase plan options “statutory” options and everything else “nonstatutory” (IRS Topic 427). Your grant agreement says which one you hold. Many employees at public tech and biotech companies hold NSOs; ISOs are more common at private and earlier-stage companies.

Sources: IRS Publication 525, Instructions for Form 6251. California follows the federal treatment of both option types (FTB Publication 1004).

Worked example 1: exercising NSOs on a $900,000 California income

Assumptions (illustrative): a married couple in Palo Alto filing jointly, $900,000 of W-2 salary between them, regular taxable income of $850,000 before the exercise, and each spouse’s salary above $184,500. One spouse exercises 10,000 NSOs with a $20 strike when the stock trades at $80. The spread is $600,000, and all of it is ordinary wage income for 2026.

• Federal income tax. Their taxable income is already above $768,700, where the 37% bracket starts for 2026. So the whole $600,000 is taxed at 37%: $222,000.
• Medicare. 1.45% plus the 0.9% Additional Medicare Tax (their wages are already above the $250,000 joint threshold): 2.35% of $600,000 = $14,100. Social Security adds nothing, because the exercising spouse’s salary already passed the $184,500 wage base for 2026.
• California income tax. 2026 California brackets are not published yet. On the 2025 joint brackets, the spread fills the 10.3% bracket to $891,542 and the 11.3% bracket above it, and the portion of taxable income over $1,000,000 also carries the 1% Behavioral Health Services Tax. That is about $71,885.
• California SDI. 1.3% of all wages for 2026, with no cap: $7,800.

Total: about $315,785, or roughly 52.6% of the spread.

Now the cash-flow problem. Employers may withhold federal tax on supplemental wages like this at a flat 22% (37% is mandatory only on supplemental wages above $1,000,000 in the year). At 22%, federal withholding is $132,000 against $222,000 of federal income tax, a gap of about $90,000 that shows up in April unless you pay it during the year. Check what was withheld for California too, because the rate used for supplemental wages can sit below the 10.3% to 11.3% marginal rates in this example.

The same exercise in Washington

The same family living in Bellevue pays the $222,000 federal tax and $14,100 Medicare, and no state income tax or SDI in 2026. Washington’s WA Cares Fund premium does apply to wages with no cap: 0.58% for 2026, about $3,480 on this spread, unless the employee holds an approved exemption (WA Cares Fund). Total: about $239,580, or 39.9% of the spread. Two caveats for this reader. First, Washington has enacted a 9.9% income tax on AGI over $1,000,000 starting January 1, 2028 (WA DOR), so a large exercise planned for 2028 or later may not be state-tax-free. Second, a later sale of the shares at a long-term gain can fall under Washington’s 7% capital gains tax above the annual standard deduction ($278,000 for 2025, the latest published).

Worked example 2: exercising ISOs and the AMT

Same California household, but this time the spouse exercises 4,000 ISOs with a $20 strike while the stock is at $80, and holds the shares. The spread is $240,000. (At a $20 grant-date value, 4,000 options are $80,000 of stock, inside the $100,000 annual limit above which ISOs first exercisable in a year are treated as NSOs, assuming no other ISOs first became exercisable that year.)

For regular tax, nothing happens in 2026. For AMT, the $240,000 is added to income. Assume their AMT income before the exercise is $880,000 (the $850,000 of regular taxable income plus about $30,000 of deductions the AMT does not allow).

So the $240,000 ISO spread costs about $49,590 of federal AMT, around 20.7% of the spread, with no shares sold to pay it and no withholding taken at exercise. Two details make it less painful than it looks:

• The AMT can come back as a credit. AMT caused by an ISO exercise is a timing item, so it generally creates a minimum tax credit you can use in later years when your regular tax exceeds your tentative minimum tax (Form 8801). At this income level, the credit can take years to recover unless income drops or you sell the shares.
• Your AMT basis goes up. The $240,000 is added to the shares’ AMT basis, which matters when you sell (Form 6251, line 2k).

The exemption phase-out is the trap for this reader. Once AMT income passes $1,000,000 (joint, 2026), every extra $1 of ISO spread also removes 50 cents of exemption, so the effective AMT rate on the spread in that zone is about 42% (28% times 1.5) until the exemption is gone at $1,280,400. Households already near $1 million of income hit this zone with a fairly small exercise.

California has its own AMT, and the ISO spread is an adjustment there too (Schedule P (540) instructions). Your preparer should run the California calculation as well before you decide how many ISOs to exercise in a year.

Selling ISO shares: qualifying vs disqualifying

If the family holds the shares at least 2 years from grant and 1 year from exercise and then sells at $110, the full $90 per share above the strike ($360,000) is a long-term capital gain. Federally that is 20% plus the 3.8% net investment income tax at their income. In California there is no lower rate for capital gains, so the gain is taxed at ordinary rates (up to 13.3% on 2025 rates). In Washington it may be subject to the 7% capital gains tax.

If they sell before those dates, the spread at exercise (or the actual gain, if lower) becomes wage income in the year of sale. Selling in the same calendar year as the exercise removes the AMT adjustment entirely (Form 6251 instructions). ISO income from a disqualifying disposition is not subject to Social Security or Medicare tax (IRC §3121(a)(22)), which is one remaining difference from an NSO.

How the exercise method changes the tax bill

The method you choose changes cash flow and risk more than the tax itself.

• Cash exercise. You pay the strike and any tax from savings and keep all the shares. For ISOs this is the only way to start the holding period on every share.
• Cashless exercise (same-day sale). The broker sells all the shares immediately. For ISOs this is a disqualifying disposition, so the spread becomes wage income and the AMT question disappears. See how a cashless exercise is taxed.
• Sell to cover. The broker sells just enough shares to pay the strike and withholding. With NSOs, the 22% withholding is often too low for this household, so consider selling extra shares or setting money aside. The mechanics are the same as for RSUs; see sell to cover vs same-day sale.
• Early exercise with an 83(b) election. Some private companies let you exercise before vesting. You then have 30 days from the transfer of the shares to file an 83(b) election with the IRS (Pub 525). If the strike equals the current value, the spread is zero and so is the tax. This does not apply to RSUs. Our guide to drafting an 83(b) election covers the steps.

Moving between California and Washington with options

Leaving California does not take your options with you for tax purposes. For NSOs, California generally taxes the share of the spread earned while you worked there, using California workdays between grant and exercise (or the date you left the job, if earlier) divided by total workdays in that period (FTB Publication 1004). A family that moves from the Bay Area to Seattle two years into a four-year grant can still owe California tax on part of the spread when they exercise from Washington. Keep a simple record of work locations by date; it is the evidence that supports the allocation.

Decisions to make before you exercise

1. Know which type you hold and the expiration date. Options usually expire within a short window after you leave the company; check your plan.
2. For NSOs, decide the year. The spread is wages in the year of exercise. Splitting a large exercise across two tax years can keep more of it out of the 1% California surcharge zone and spread the withholding gap.
3. For ISOs, size the exercise to your AMT room. Ask your preparer for the spread you can add this year before AMT applies, and how much more it costs above that.
4. Fund the tax before you exercise. NSO withholding is often short; ISO exercises have none. Use estimated payments or a higher W-4 withholding for the rest of the year.
5. Decide how much single-stock risk you want. Holding ISO shares for the long-term rate means a year of price risk on top of your salary and unvested equity from the same employer.

Common mistakes we see

• Treating the 22% withholding on an NSO exercise as the tax owed.
• Exercising ISOs in December without running the AMT, then learning in April that the bill is due on shares that have since fallen.
• Assuming Washington residency removes all state tax on options earned in California.
• Losing Form 3921, which you need to compute both the AMT adjustment and the later sale correctly.

What to write down for your kids

Equity decisions are some of the largest money decisions a W-2 family makes, and children rarely see the reasoning. A one-page note works: what you held, why you exercised when you did, how much you kept, and what you would do differently. As Kevin Luu puts it: “Your kids will inherit your money. Will they inherit your judgment?” That note is the start of a FamilyKnowledge® Library entry, and our family governance work helps families keep these records over time.

Frequently asked questions

Are ISOs taxed at exercise?

Not for regular federal or California income tax. The spread between the stock’s value and your strike price is, however, added to income for the alternative minimum tax. At $750,000 or more of household income, an ISO exercise of a few hundred thousand dollars of spread can trigger AMT in the year of exercise, even if you keep every share. Some or all of that AMT can return later as a credit.

Do I pay tax twice on stock options?

No, if the return is prepared correctly. For NSOs, the spread you paid tax on at exercise becomes part of your cost basis, so only the gain after exercise is taxed at sale. A common error is reporting the broker’s 1099-B basis (often just the strike price) without adjusting it, which taxes the spread a second time. Check Form 8949 against your W-2 or Form 3921.

Is Social Security tax due on an NSO exercise?

The spread is wages, so Social Security applies until you reach the annual wage base ($184,500 for 2026). Most households in this income range reach it through salary alone, so in practice only Medicare (1.45% plus 0.9% above the threshold) is added. In California, SDI of 1.3% applies to the full spread with no cap.

Next step

Before your next exercise, put the grant agreement, your most recent pay stub and last year’s return in front of your tax preparer and ask for two numbers: the tax on the exercise, and how much is already withheld. If you want a second look across RSUs, options and the rest of your household picture, our tax management team runs a Tax & Wealth Assessment for families at the Age Five Family Office™. For related reading, see how RSUs count as income and RSUs at private companies.

This is general education, not individual tax advice. The right move depends on the family’s full picture.

Written by

Kevin Luu

Co-Founder and Chief Learning Officer, Bright Advisers

Kevin has advised high-income W-2 tech and biotech families since 2015, and leads the education-first Age Five Family Office from Brea, California.

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