Capital Gains Tax on Stock Options: How ISOs and NSOs Are Taxed in California and Washington

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

Stock options are taxed as capital gains only on the growth after you exercise, or on the whole gain if you hold incentive stock options (ISOs) long enough. The spread at exercise on non-qualified options (NSOs) is taxed as wages, at ordinary rates plus Medicare. ISOs avoid regular tax at exercise but can trigger the alternative minimum tax (AMT), and they qualify for long-term capital gains only if you sell more than two years after grant and more than one year after exercise.

For a two-earner household in California or Washington with $750,000 or more of W-2 income, the gap between those outcomes is large. On a $400,000 spread, the difference between ordinary income and long-term capital gains is about $52,800 of federal tax in our example below. In California the state share barely changes, because California taxes capital gains as ordinary income. So the real decisions are when to exercise, how much, and whether the federal savings are worth the risk of holding one stock for a year.

How each type of stock option is taxed, step by step

There are three moments that matter: grant, exercise and sale. Your option agreement and the form your employer issues (Form 3921 for ISO exercises, your W-2 for NSO income) tell you which rules apply. The IRS summary is in Topic 427, Stock Options.

The ISO holding periods come from IRC §422(a)(1) (no sale “within 2 years from the date of the granting of the option nor within 1 year after the transfer of such share”), and the cap on ordinary income in an early sale is §422(c)(2). The payroll tax exclusion for ISO stock is IRC §3121(a)(22).

One more ISO rule catches large grants: ISOs that first become exercisable in a calendar year above $100,000 of stock, valued at grant-date fair market value, are treated as NSOs (IRC §422(d)). Many senior grants are part ISO and part NSO for this reason. Check the split before you plan.

Worked example: a $900,000 household exercises $400,000 of spread

Assumptions (illustrative): married filing jointly, $900,000 of combined W-2 wages for 2026, standard deduction of $32,200, so $867,800 of federal taxable income before any option income. The spouse who holds the options already earns more than the $184,500 Social Security wage base for 2026, so no Social Security tax applies to the spread. That spouse holds 4,000 options with a $20 strike on stock now worth $120, so the spread is $400,000.

If they are NSOs: taxed as wages at exercise

The family is already in the 37% federal bracket for 2026 (it starts at $768,700 of taxable income), so every dollar of spread is taxed at 37%. Medicare adds 1.45% plus the 0.9% Additional Medicare Tax on wages above $250,000 for joint filers.

California note: 2026 California brackets are not yet published, so this uses the 2025 joint schedule and assumes $870,000 of California taxable income before the options: 10.3% up to $891,542, 11.3% above that, plus the 1% Behavioral Health Services Tax on taxable income over $1,000,000 (FTB 2025 rate schedules). Washington note: the table leaves out the WA Cares long-term care premium (0.58% of wages, for employees without an approved exemption), so check how it applies to your option income.

The cash surprise is withholding. Employers often withhold the 22% federal supplemental rate (37% only on supplemental wages over $1,000,000 in the year), per IRS Publication 15. On $400,000 that is $88,000 withheld against $148,000 owed, a $60,000 federal gap to cover with estimated payments or extra withholding. Our guide on tax on a cashless exercise covers how a same-day sale changes the cash side.

After exercise, the NSO shares have a cost basis of $120. Any growth from there is a capital gain: long-term if held more than one year.

If they are ISOs: no regular tax at exercise, but AMT

Exercising and holding ISOs adds the $400,000 spread to AMT income only. For 2026 the joint AMT exemption is $140,200, and it phases out by 50 cents per dollar of AMT income over $1,000,000 (fully gone at $1,280,400). AMT is 26% on the first $244,500 of taxable excess and 28% above (IRC §55(b); 2026 amounts from Rev. Proc. 2025-32).

• Regular federal tax on $867,800: $206,583.50 + 37% of $99,100 = $243,250.50.
• AMT income: $867,800 + $32,200 standard deduction added back + $400,000 spread = $1,300,000. The exemption is fully phased out.
• Tentative minimum tax: 26% of $244,500 ($63,570) + 28% of $1,055,500 ($295,540) = $359,110.
• AMT owed on top of regular tax: about $115,860, due with the 2026 return even though no shares were sold.

Two details matter here. First, this family could exercise roughly $117,600 of spread in 2026 before owing any AMT, under these assumptions. Between $1,000,000 and $1,280,400 of AMT income, each extra dollar of spread both adds income and removes 50 cents of exemption, so the effective AMT rate on that slice is 42% (28% x 1.5). Second, AMT paid on ISO exercises usually becomes a credit you can use in later years when regular tax exceeds AMT, claimed on Form 8801. It is mostly a timing cost, but a real cash cost in the year you exercise.

California has its own AMT, and it also counts the ISO spread. The FTB equity compensation guidelines (Publication 1004) say that for “federal and California alternative minimum tax (AMT), you must treat stock acquired through the exercise of an incentive stock option as if the option were a nonstatutory stock option.”

Selling the ISO shares: qualifying versus early sale

For 2026 the 20% long-term rate applies to joint taxable income above $613,700, and the 3.8% net investment income tax applies above $250,000 of modified AGI. So the federal prize for holding is about $52,800 on this grant, assuming the price holds. If the stock falls 15% during the year you wait, the $72,000 drop in value wipes out more than the tax saved.

California versus Washington: where the savings actually come from

California. California has no lower rate for capital gains (FTB), so a qualifying ISO sale and an early sale are taxed at the same state rate, up to 13.3% at the top (2025 rates). The main state-level differences are that NSO spread is wages subject to 1.3% SDI with no cap for 2026, and that the ISO spread counts toward California AMT in the exercise year. For a California family, holding ISOs for a qualifying sale is a federal decision.

Washington. There is no tax on wage income in 2026, so NSO spread carries only federal tax and Medicare. Long-term capital gains on stock are subject to Washington’s 7% capital gains tax above the standard deduction ($278,000 for 2025, the latest published; 2026 not yet posted by DOR), rising to 9.9% on taxable gains over $1,000,000. In our example, a $400,000 qualifying ISO gain with no other gains that year would owe about $8,540 to Washington ($122,000 x 7%, using the 2025 deduction). Also plan for Washington’s new 9.9% income tax on AGI over $1,000,000, effective January 1, 2028 (DOR). Multi-year exercise plans that run past 2027 should model it.

Moving from California to Washington. A move does not erase California’s claim on options you earned while working in California. For NSOs, FTB Publication 1004 describes allocating the income by California workdays from grant date to exercise date, divided by total workdays in that period. Keep a record of your work locations and dates.

Ways high-income families reduce the tax on stock options

1. Size ISO exercises to the AMT crossover each year. Exercising up to the point where AMT starts (about $117,600 of spread for the family above) spreads the cost over several years. A bonus year or a year one spouse is on leave changes the number, so recalculate each fall.
2. Exercise ISOs early in the calendar year if you plan to hold. You learn by December whether the price held, and if it dropped you can still sell in the same year as a disqualifying sale, which removes the AMT adjustment and caps ordinary income at your actual gain.
3. Time NSO exercises to lower-income years where possible, keeping in mind the option expiration date and that at $900,000 of wages you are likely already in the top bracket. For many of our families the bigger lever is avoiding the withholding gap, not the bracket.
4. Use early exercise with an 83(b) election only if the plan allows it, usually at private companies where the spread is near zero. The election must be filed with the IRS no later than 30 days after the shares are transferred (IRS Publication 525). See our guide to drafting an 83(b) election letter. 83(b) does not apply to RSUs.
5. Give long-term shares, not cash, to charity. Donating shares held more than one year generally lets you deduct fair market value without paying tax on the gain, within the limits in IRS Publication 526. Gifting ISO shares before the holding periods are met counts as a disqualifying disposition.
6. Diversify on a schedule. Many families also hold RSUs from the same employer. A written sell plan that sets a maximum share of net worth in one stock keeps the tax tail from wagging the risk dog. If your RSUs are part of the picture, see how RSU income is taxed, and if your company is private, how a tender offer works.

Common mistakes we see

• Assuming all option gains are capital gains. NSO spread is always wages.
• Exercising ISOs in December and holding, then learning about AMT in April.
• Treating 22% withholding as the tax owed. At the 35% and 37% brackets it usually leaves a balance due.
• Holding ISOs a full year in California for a saving that is only federal, with half the family’s net worth in one stock.
• Letting vested options expire after leaving a job. Check your post-termination exercise window in the plan document.

What to write down for your kids

Equity compensation is where many of these families build most of their wealth, and the reasoning behind each exercise is easy to lose. A one-page note per decision is enough: what you exercised, why that amount, what you expected, and what actually happened. Your children will not remember the stock price. They can learn from how you weighed a tax saving against the risk of owning too much of one company. Conversations fade. Documentation compounds.

Frequently asked questions

Are stock options taxed as capital gains?

Partly. For NSOs, the spread at exercise is taxed as wages, and only growth after exercise is a capital gain. For ISOs, the entire gain above the strike price is long-term capital gain if you sell more than two years after grant and more than one year after exercise. Sell earlier and the spread at exercise is taxed as ordinary income, though without Social Security or Medicare tax.

Do I pay tax when I exercise stock options?

With NSOs, yes: the spread is added to your wages for that year and your employer withholds, often at only 22% federal. With ISOs, there is no regular income tax at exercise if you hold the shares, but the spread counts toward the federal and California alternative minimum tax. If you exercise and sell ISOs in the same calendar year, AMT does not apply to those shares.

Is the AMT on ISOs lost money?

Usually not entirely. AMT caused by ISO exercises generally creates a minimum tax credit, claimed on Form 8801, that offsets regular tax in later years when your regular tax exceeds your tentative minimum tax. At high W-2 incomes the credit can take several years to use. It is mainly a cash-flow cost in the exercise year, which is why the size of each year’s exercise matters.

Next step

Pull your option grant summary and last year’s return, and list each grant’s type (ISO or NSO), strike price, vesting dates and expiration date. With that list, a tax adviser can model this year’s AMT crossover and the withholding gap. If you would like us to run those numbers alongside your RSUs and the rest of your family’s plan, our Tax & Wealth Assessment starts there. You can also see how we handle equity compensation for families.

This is general education, not individual tax advice. The right move depends on your 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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