How Are ISOs Taxed? A Guide for California and Washington Families Earning $750k+

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

ISOs (incentive stock options) are not taxed when they are granted and, for regular income tax, not when you exercise them. The tax shows up in two places instead: the spread at exercise (market value minus your strike price) counts toward the alternative minimum tax (AMT) in the year you exercise and hold, and the sale is taxed either as long-term capital gain (if you meet the holding periods) or partly as wages (if you sell early). For a California or Washington household already earning $750k or more in W-2 pay, the AMT piece is usually what decides how many options to exercise and when.

Below: how each stage works under 2026 federal rules, a worked example for a two-income California family, how the answer changes in Washington or after a move, and the decision you actually have to make.

How ISOs work, stage by stage

The holding period test: you must not sell until the later of 2 years after the grant date and 1 year after the shares were transferred to you at exercise. Sources: IRS Publication 525 (Statutory Stock Options), IRS Topic 427, and FTB Publication 1004. Your employer reports each exercise on Form 3921, which carries the grant date, exercise date, strike and market value you need for all of the above.

One detail that surprises people: the wage income from a disqualifying sale is not subject to Social Security or Medicare tax (IRC §3121(a)(22)), unlike an RSU vest or a non-qualified option exercise.

Why AMT is the real cost of exercising ISOs at $750k+

AMT is a parallel tax calculation. You compute your tax the normal way, then again under AMT rules (no state and local tax deduction, plus the ISO spread added back), and pay whichever is higher. For 2026, the AMT rules for married couples filing jointly are:

• Exemption: $140,200, reduced by 50 cents for every dollar of AMT income over $1,000,000, and gone entirely at $1,280,400 (Rev. Proc. 2025-32; the faster 50% phase-out comes from the One Big Beautiful Bill Act).
• Rates: 26% on the first $244,500 of AMT income above the exemption, 28% above that (IRC §55(b), threshold from Rev. Proc. 2025-32).

So, at what income level does AMT kick in? For most W-2 families at this income, almost never on wages alone. The 37% regular bracket starts at $768,700 of taxable income for 2026, so the regular marginal rate at this income (35% to 37%) is well above the 28% AMT rate, and with the federal SALT deduction already phased down to $10,000 for most $750k+ households, there is little to add back. An ISO exercise is the most common thing that pushes this reader into AMT. The question is how much spread you can absorb before it does.

Worked example: a $850k California household exercising ISOs

Assumptions (illustrative, 2026 federal rules): married filing jointly, California residents, two children. Combined W-2 wages $850,000. Itemized deductions $70,000 ($10,000 state and local tax after the phase-down, $40,000 mortgage interest on acquisition debt, $20,000 charity). Starting in 2026, households in the 37% bracket have itemized deductions trimmed by 2/37 (One Big Beautiful Bill Act §70111), here about $3,784, so regular taxable income is about $783,784. One spouse works at a late-stage private biotech and holds 20,000 vested ISOs with a $5 strike. The latest 409A value is $30 a share, so the spread is $25 a share.

Step 1: tax without exercising

Regular federal tax on about $783,784: $206,583.50 on the first $768,700, plus 37% of about $15,084, for about $212,165. AMT income is $790,000: the $10,000 of state and local tax is added back, and the 2/37 trim does not apply for AMT (IRC §56(b)(1)), so only the $60,000 of mortgage interest and charity is deducted from $850,000 of wages. After the full $140,200 exemption, the AMT base is $649,800, and the tentative minimum tax is about $177,054. That is lower than the regular tax, so no AMT.

Step 2: how much spread fits before AMT

The gap between the two numbers is about $35,100. Each extra dollar of ISO spread adds 28 cents of tentative minimum tax at this level, so roughly $125,000 of spread can be absorbed with no AMT at all. At $25 a share, that is about 5,000 shares this year.

Step 3: exercising all 20,000 shares

The spread is $500,000. AMT income becomes $1,290,000, which is past $1,280,400, so the exemption is zero. Tentative minimum tax: 26% of $244,500 ($63,570) plus 28% of $1,045,500 ($292,740), about $356,310. Subtract the regular tax and the family owes about $144,100 of federal AMT, in cash, on shares they cannot yet sell. They would also add the $100,000 strike cost and check California AMT on Schedule P (540).

The AMT is not always lost. AMT caused by ISOs creates a credit you can claim on Form 8801 in later years when your regular tax exceeds your tentative minimum tax, and California has its own credit on form FTB 3510. Because your AMT basis in the shares is $30 rather than $5, a later qualifying sale often frees up much of that credit. But recovery depends on future income and can take years, which is why staged exercises across several tax years are the common pattern for families who expect a liquidity event.

Selling: qualifying versus disqualifying, in California and Washington

Suppose the company later goes public and the family sells all 20,000 shares at $40, more than 2 years after grant and 1 year after exercise. The $700,000 gain ($35 a share) is long-term capital gain federally. At this income it falls in the 20% bracket (above $613,700 of taxable income for 2026) plus the 3.8% Net Investment Income Tax. California taxes the whole gain at ordinary rates, up to 13.3% (2025 schedule; 2026 California brackets are not yet published).

If they sold the same shares 6 months after exercise instead, $500,000 (the spread at exercise) would be W-2 wages taxed at 37% federally, and only the last $200,000 would be capital gain, and short-term at that. In California the total state bill is similar either way, because California does not reward the holding period. The holding period saves federal tax, not California tax.

In Washington the math is different. There is no state income tax on the wage piece in 2026. A qualifying sale is a long-term capital gain that can fall under Washington’s 7% capital gains tax on gains above the standard deduction ($278,000 for 2025, the latest published figure; WA Department of Revenue), rising to 9.9% on taxable gains over $1,000,000. Washington has also enacted a 9.9% income tax on AGI over $1,000,000 starting in 2028 (WA DOR), so families planning a sale in 2028 or later should check how DOR guidance treats ISO income.

ISOs when you move between California and Washington

Moving does not erase California’s claim. Per FTB Publication 1004:

• A qualifying sale made after you become a nonresident is not taxed by California, even if you earned the options there. But the AMT adjustment from an exercise while you were a resident still belongs on your California return for that year.
• A disqualifying sale made after you leave is treated like a non-qualified option exercise, and California taxes the wage portion to the extent it was earned in California.
• Moving into California and then selling makes the whole gain California-taxable, because you are a resident at the sale.

For a Seattle family considering a move to the Bay Area (or the reverse), the order of exercise, move and sale can change the state bill by tens of thousands of dollars.

Two rules that catch high earners

The $100,000 limit. Only $100,000 of options, measured at grant-date value, can first become exercisable as ISOs in any calendar year. The rest are treated as non-qualified options (IRC §422(d)). A grant of 40,000 options at a $10 grant-date value vesting evenly over four years puts exactly $100,000 into each year. A grant twice that size would be half ISO, half non-qualified, even though the paperwork says ISO.

Early exercise. Some private companies let you exercise before the options vest. Without an election, the AMT adjustment is measured when the shares vest, at whatever the value is then. Filing a Section 83(b) election within 30 days of the transfer measures it at exercise instead, which can be close to zero if you exercise at the grant price. See our guide to drafting a Section 83(b) election letter. The 30-day deadline is strict, and the strike price is cash at risk if the company fails.

The decision your family actually has to make

1. How much cash can you put at risk? Strike price plus any AMT, on a private stock you may not be able to sell for years. Keep it a modest share of liquid net worth.
2. How much AMT room do you have this year? Run the number each fall with your actual wages, RSU vests and bonus, then exercise up to that point before December 31.
3. Is a liquidity event coming? A tender offer or IPO changes the answer. See how tender offers work and the tax on a cashless exercise.
4. How concentrated are you already? If your household also holds employer RSUs, exercising ISOs adds to the same bet. Our investment risk management work starts here.
5. When do the options expire? ISOs typically must be exercised within 3 months of leaving the company to keep ISO status (Publication 525). Know that date before you change jobs.

Common mistakes

• Exercising a large block in December without running AMT, then finding a five-figure bill in April with no shares you can sell.
• Losing track of AMT basis. Your broker’s Form 1099-B typically shows regular basis only; you need records of both to claim the AMT credit.
• Assuming the holding period helps your California bill. It helps federally; California taxes the gain as ordinary income either way.
• Forgetting withholding. Neither the exercise nor a disqualifying sale typically has enough tax withheld, so estimated payments are often needed.

What to document for your kids

An ISO exercise is one of the clearest money decisions a family makes: you risk cash today on your own judgment about a company. Write a one-page Decision Memo: what you exercised, why that number, what you were willing to lose, and what happened. Years later it is a better lesson than the outcome alone. As Kevin Luu puts it: “Your kids don’t need to inherit your portfolio. They need to inherit your decision-making process.” The FamilyKnowledge® Library is built for exactly this kind of record.

Frequently asked questions

Do I pay tax when I exercise ISOs?

Not regular income tax. But if you hold the shares past December 31, the spread counts as income for the alternative minimum tax, federally and in California. If your AMT figure ends up higher than your regular tax, you pay the difference with that year’s return. If you sell in the same calendar year, there is no AMT adjustment, but the spread is taxed as wages.

Are ISOs better than RSUs?

They can be, because a qualifying sale turns the growth into long-term capital gain federally, while RSUs are taxed as wages at vest. But ISOs require cash to exercise, carry AMT risk, and need a long hold in one stock. For California residents the state tax is similar either way. See our guide to how RSUs are taxed as income.

Can I get the AMT back?

Often, partly or fully. AMT from ISO exercises generates a minimum tax credit claimed on Form 8801 in later years when your regular tax is higher than your tentative minimum tax. California has a similar credit on FTB 3510. A later qualifying sale, where your AMT basis is higher than your regular basis, is often when most of it comes back.

Next step

Before December, pull your Form 3921s or grant summary, your year-to-date pay stub and your expected RSU vests, and have your AMT room calculated for this tax year. If you want help with the numbers and the multi-year exercise plan, our tax management team does this as part of the Tax & Wealth Assessment.

This is general education, and 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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