Stock Option Plans: When to Exercise and When to Sell

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

With employee stock options, when to sell depends on the type. For nonqualified stock options (NSOs), most of the tax is set the day you exercise, so holding the shares afterward is mainly a bet on one company. For incentive stock options (ISOs), holding at least two years from grant and one year from exercise can turn the gain into long-term capital gain on your federal return, but you carry the stock price risk and possibly alternative minimum tax (AMT) while you wait.

This page covers the option side of a stock plan: what an option is, how NSOs and ISOs are taxed in 2026, what changes for a family in California versus Washington, and a decision checklist for when to exercise and when to sell. If your equity is RSUs or an ESPP, those have their own rules, covered in our guides on sell to cover versus a same-day sale and when to sell ESPP shares.

What a stock option plan actually gives you

A stock option is the right to buy a set number of company shares at a fixed price (the strike or exercise price) for a set period, usually up to ten years from grant. Options vest over time, often four years. Once vested, you can exercise: pay the strike price, receive shares, and owe tax depending on the type. The difference between the share price and the strike price at exercise is called the spread, or bargain element.

Your grant agreement names the type. Public companies and later-stage private companies often grant NSOs to executives and directors. Earlier-stage companies often grant ISOs to employees. Many people at pre-IPO companies hold both, because ISOs that first become exercisable in one calendar year above $100,000 of stock (measured at the grant-date value) are treated as NSOs for the excess under IRC Section 422(d).

How NSOs and ISOs are taxed in 2026

The IRS summarizes these rules in Topic 427, Stock Options and Publication 525. Withholding rates are from Publication 15 (2026).

Worked example 1: NSO exercise for a $900,000 California household

Assumptions (illustrative): married filing jointly, $900,000 of W-2 wages in 2026, standard deduction, no other supplemental pay. One spouse, a director at a Bay Area biotech, exercises 10,000 vested NSOs with a $20 strike when the stock is at $80. The spread is $600,000, and it is added to their W-2 wages.

• Federal income tax. Taxable income before the exercise is about $867,800 ($900,000 minus the $32,200 standard deduction), already above the 37% bracket that starts at $768,700 for 2026. The whole spread is taxed at 37%: about $222,000.
• Medicare. 1.45% plus the 0.9% Additional Medicare Tax (wages are already over $250,000): 2.35% of $600,000, about $14,100. Social Security tax is likely already maxed if the exercising spouse’s wages for the year are above the $184,500 wage base for 2026.
• California income tax. Using the 2025 schedules (2026 schedules were not published when this was reviewed) and assuming $880,000 of California taxable income before the exercise, the spread runs through the 10.3% and 11.3% brackets, plus the 1% Behavioral Health Services Tax on taxable income over $1,000,000: about $72,500.
• California SDI. 1.3% of all wages with no cap for 2026: $7,800.

Total: roughly $316,400, or about 53% of the spread. If the employer withholds at the 22% flat rate, federal withholding covers only $132,000 of the $222,000 federal income tax, leaving a gap of about $90,000 that needs an estimated payment or extra withholding to avoid an April surprise.

What this means for when to sell: after exercise, the family owns $800,000 of stock with a tax basis of $80 a share. Holding longer changes nothing about the $316,400 already owed. In California, holding more than a year also does not lower the state rate on later gains, because California has no lower rate for capital gains. Unless the family has a clear reason to want more of this one stock, a cashless exercise or a same-day sale of some or all shares is often the cleaner choice.

Worked example 2: ISO exercise for a Washington family

Assumptions (illustrative): married filing jointly, $800,000 of W-2 wages in 2026, living in Seattle. One spouse works at a late-stage private company and exercises 8,000 ISOs with a $5 strike when the latest 409A value is $30. The spread is $200,000. There is no regular income tax at exercise.

The AMT question. For AMT, the $200,000 spread is added back. AMT income here is roughly $1,000,000, right at the 2026 point where the $140,200 joint exemption starts to phase out (50 cents for every dollar above $1,000,000). A rough calculation, before itemized deductions and other adjustments, shows tentative AMT of about $235,900 against regular tax of about $206,300, so the family would owe about $29,600 of AMT for 2026. Some or all of that may come back in later years as a minimum tax credit (Form 8801), but only in years when regular tax exceeds tentative minimum tax, so the timing depends on the family’s income in those years.

The sale decision a year later. Say the company is acquired and the shares are worth $30 when the holding periods are met:

• Qualifying sale. The $200,000 gain is long-term capital gain: 20% plus the 3.8% Net Investment Income Tax, about $47,600 federal. Washington’s 7% capital gains tax applies only above the standard deduction ($278,000 for 2025, the latest published), so likely $0 here.
• Disqualifying sale (sold within the holding period). The $200,000 spread becomes ordinary income, about $74,000 federal at this income, but no AMT for the exercise year if the sale happens in the same calendar year.

The qualifying route can save about $26,400 of federal tax on the sale in this example (before counting the AMT paid at exercise, which may come back later as a credit), while the family carries the stock for a year with no way to sell if the company stays private. If the value drops from $30 to $15 during that year, the family has paid AMT on a $200,000 spread that is now worth $80,000. That is the trade every ISO holder is making.

California versus Washington for option holders

• California taxes NSO spreads as wages, adds 1.3% SDI with no cap for 2026, and taxes all capital gains at ordinary rates (up to 12.3% plus the 1% Behavioral Health Services Tax on taxable income over $1,000,000, using 2025 schedules). The federal benefit of a qualifying ISO sale is real; there is no extra California benefit.
• Washington has no wage income tax in 2026, so an NSO spread carries no state income tax (federal income tax, Social Security up to the wage base, and Medicare still apply). Long-term gains face Washington’s capital gains tax: 7% on taxable gains above the standard deduction, 9.9% above $1,000,000. A new 9.9% tax on individual AGI over $1,000,000 starts January 1, 2028 (WA DOR), which matters for families planning a large exercise or sale in 2028 or later.

A checklist for deciding when to exercise and when to sell

1. Know your deadlines. Expiration date, and the post-termination window if you leave. ISOs generally must be exercised within three months after employment ends to keep ISO treatment (IRC Section 422(a)(2)); after that they are taxed as NSOs. A missed deadline means the options are gone.
2. Size the tax before you exercise. NSO: wages, withholding gap, estimated payment. ISO: AMT for the year, and cash to pay it.
3. Decide how much of the net worth one company should be. Many families set a cap (for example, no single stock above 10% to 20% of investable assets) and sell down to it on a schedule.
4. For ISOs, pick a lane in writing. Exercise and hold for a qualifying sale, or exercise and sell in the same year to skip AMT. Mixing the two by accident is how families end up paying AMT on stock they later sell at a loss.
5. Plan around liquidity events. At a private company, an employer tender offer or an acquisition may be the only chance to sell. Early exercise with an 83(b) election (filed within 30 days) is a separate decision with its own risk.
6. Coordinate both spouses’ equity. Two sets of grants, one tax return. An NSO exercise by one spouse changes the AMT math on the other’s ISOs.

Common mistakes

• Treating 22% withholding on an NSO exercise as the tax owed. At this income the federal rate is usually 35% to 37%.
• Holding NSO shares for “long-term” treatment when the spread has already been taxed as wages. Only the gain after exercise can become long-term.
• Exercising ISOs late in December without running AMT first, or exercising in January and forgetting the AMT estimate by year end.
• Letting one stock grow past half of the family’s net worth because selling feels like disloyalty to the employer.

What to write down for your kids

Equity decisions are some of the largest money decisions a family makes, and children usually see only the outcome: a new house, or a stressful year when the stock fell. A one-page Decision Memo (what you held, the price, why you sold or held, what you would do differently) turns an exercise into something they can learn from later. As Kevin Luu puts it: “Your kids don’t need to inherit your portfolio. They need to inherit your decision-making process.”

Frequently asked questions

Should I sell stock right after exercising NSOs?

Many families do, unless they want more exposure to the company. The spread is taxed as wages at exercise whether you sell or not, so holding only adds price risk. Selling at once also raises cash for the tax not covered by the 22% withholding. In California there is no lower state rate for gains held longer, which makes holding NSO shares even less attractive.

Is a qualifying ISO sale always worth waiting for?

No. It lowers the federal rate on the spread from ordinary rates to long-term capital gain rates, but you may pay AMT now and carry a single stock for at least a year. If the price falls enough during that year, the tax saved is smaller than the value lost. Families with a large share of net worth in one company often split the decision.

Do California and Washington tax stock options the same way?

No. California taxes the NSO spread as wages, adds 1.3% SDI for 2026, and has no lower capital gains rate. Washington has no wage income tax in 2026, so the NSO spread carries no state income tax, but it taxes long-term gains above its standard deduction at 7%, and adds an income tax on AGI over $1,000,000 from 2028.

Next step

Before your next exercise, list every grant you and your spouse hold with its type, strike, vest dates and expiration, and estimate the tax for this year. If you want a second set of eyes on that list, the equity compensation and tax management pages explain how Age Five Family Office™ works with families on these decisions.

This is general education, not individual tax advice. The right move depends on your family’s full picture, including other income, deductions and both spouses’ grants.

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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