When Are Stock Options Taxed? Grant, Vest, Exercise and Sale for California and Washington Families

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

Employee stock options are generally not taxed when they are granted or when they vest. With a nonqualified stock option (NSO), tax hits the day you exercise: the spread between the stock price and your strike price is taxed as wages, and tax is withheld then. With an incentive stock option (ISO), there is no regular income tax at exercise, but the spread can trigger alternative minimum tax (AMT) for that year, and the main tax event is the day you sell.

That is the rule. For a California or Washington household already earning $750,000 or more, the harder question is when the cash actually leaves your account, because withholding at exercise is usually well short of the real bill, and an ISO exercise has no withholding at all. This page walks through each taxable moment, then runs the numbers for a two-earner family.

The four moments in an option’s life, and which ones are taxed

Your grant agreement or equity portal says which type you hold. The IRS treats ISOs as “statutory” options and NSOs as “nonstatutory” options (IRS Topic 427; IRS Publication 525).

Two extras. If your plan allows early exercise of unvested options, you can make an 83(b) election; if you do, it must be filed with the IRS within 30 days of the transfer (Pub 525). And ISOs that first become exercisable in one calendar year above $100,000 of stock, valued at grant-date fair market value, are treated as NSOs for the excess (IRC §422(d)). Many people who think they hold only ISOs actually hold a mix.

When NSO tax is due: at exercise, and again in April

An NSO exercise is paid like a bonus. Your employer typically withholds federal tax at the 22% optional flat supplemental rate (it may instead use the aggregate method, and 37% is mandatory on supplemental wages above $1,000,000 in the calendar year), plus Medicare, and in California state tax at 10.23% plus SDI (IRS Pub 15, 2026; EDD DE 44, 2026). For a family whose top federal bracket is 35% or 37%, that withholding is short, and the gap is due with your return or through estimated payments.

Worked example: a $400,000 NSO exercise in California

Assumptions: a married couple in San Mateo County filing jointly, combined W-2 wages of $900,000 in 2026. Federal taxable income before the exercise is $860,000, already inside the 37% bracket (which starts at $768,700 for 2026). The exercising spouse has already been paid more than $200,000 in wages by this employer in 2026 (so is past the $184,500 Social Security wage base and the $200,000 point where the employer must withhold Additional Medicare Tax), the employer uses the 22% flat rate, and the spouse has no other supplemental wages that would push the year above $1,000,000. They exercise 5,000 NSOs with a $20 strike when the stock is $100, and hold the shares. Spread: 5,000 x $80 = $400,000.

California note: 2026 California brackets were not yet published when this was reviewed, so the state line uses the 2025 joint schedule, with California taxable income of $870,000 before the exercise. The spread is taxed at 10.3% up to $891,542, then 11.3%, plus the 1% Behavioral Health Services Tax on taxable income above $1,000,000 (FTB 2025 rate schedules).

The family is roughly $66,765 short. That gap is the part people miss. A second trap sits on the California side: once your California AGI for the year is $1,000,000 or more, you cannot rely on 110% of last year’s tax to avoid an underpayment penalty. Your estimates must be based on the current year’s tax (FTB 2026 Form 540-ES instructions). Here the exercise lifts AGI from about $900,000 to about $1,300,000, so the state shortfall typically needs to be covered by estimated payments during the year, not left for April. Federally, households with prior-year AGI over $150,000 can generally avoid the penalty by paying in 110% of the prior year’s tax (IRS Pub 505), but the balance is still due by April 15.

The same exercise in Washington

A Seattle family with the same numbers owes the same $148,000 federal tax and $9,400 Medicare, plus the WA Cares premium of 0.58% on wages ($2,320). Washington has no wage income tax in 2026 (WA DOR), so the total is about $159,720, roughly 40% of the spread. Two caveats for this reader. Washington enacted a 9.9% income tax on AGI above $1,000,000 starting January 1, 2028, and how it treats option income is still pending DOR guidance. And when the shares are later sold, long-term gains count toward Washington’s capital gains tax: 7% above the standard deduction ($278,000 for 2025, the latest published), and 9.9% on taxable gains above $1,000,000.

When ISO tax is due: the AMT bill arrives next April

Take the same 5,000 options as ISOs, exercised in 2026 and held into 2027. Nothing is withheld, and the spread is not on your W-2. But the $400,000 is added to alternative minimum taxable income (Form 6251 instructions, line 2i).

• Regular federal tax on $860,000 of taxable income: $206,583.50 + 37% of $91,300 = $240,364.50.
• AMT income: $870,000 (taxable income plus $10,000 of state and local tax added back) + $400,000 = $1,270,000.
• AMT exemption for 2026: $140,200, reduced by 50 cents per dollar above $1,000,000, so $140,200 minus $135,000 = $5,200.
• Tentative minimum tax: ($1,270,000 minus $5,200) x 28% minus $4,890 = $349,254.
• AMT owed: $349,254 minus $240,364.50 = about $108,890, due with the 2026 return.

Without the exercise, this family owes no AMT, so the whole $108,890 is caused by the ISOs, about 27% of the spread. California has its own AMT and the ISO spread counts there too (FTB Publication 1004), which can add to the bill. Federal AMT paid because of ISOs can generally come back as a minimum tax credit in later years (Form 8801), but that is cash out now and recovered slowly.

The AMT figures use the 2026 exemption, phase-out and 28% bracket from IRS Rev. Proc. 2025-32. The $4,890 is 2% of the $244,500 threshold, following the Form 6251 line 7 formula.

The ISO decision: hold for long-term gain, or sell the same year

If you sell ISO shares in the same calendar year you exercise, no AMT adjustment applies, and the spread is taxed as wages instead (Pub 525). In California that sale looks a lot like an NSO, because California taxes all capital gains as ordinary income anyway. The ISO’s main benefit for a California family is federal: holding long enough turns the spread into long-term gain taxed at 20% plus the 3.8% net investment income tax at this income, instead of 37% plus Medicare.

The cost of waiting is risk. If you exercise in March, hold into the next year, and the stock falls, you still owe AMT computed on the March price. A practical checklist before exercising and holding ISOs:

1. Can you pay the projected AMT in cash by April without selling other shares at a bad time?
2. Would you still be comfortable if the stock fell by half before the qualifying date?
3. How much of your net worth is already in this one company through RSUs, ESPP and options?
4. Is a sale planned within 12 months anyway? If so, a same-year disqualifying sale may be cleaner.

Moving between California and Washington with unexercised options

Moving to Washington before you exercise does not take option income out of California’s reach. California generally sources option wages by workdays, the method FTB describes: California workdays from grant to exercise divided by total workdays in that period (or to the date your job ended, if earlier). A nonresident who exercises NSOs, or makes a disqualifying ISO sale, still owes California tax on that share (FTB Publication 1004). If a move is planned, record your workdays by state now.

Common mistakes we see

• Treating 22% federal withholding as the tax. At 35% or 37%, it is a down payment.
• Missing the California $1,000,000 AGI rule and paying an underpayment penalty on a year that was otherwise fully withheld.
• Exercising ISOs late in the year to “start the clock” without modeling AMT, then watching the stock drop before April.
• Using the 1099-B cost basis as is. For options granted since 2014, it leaves out income you already reported at exercise, so you must adjust it on Form 8949 or pay tax twice. ISO shares also carry a separate AMT basis (Pub 525).
• Assuming a move out of California ends California tax on options earned there.

What to write down for your kids

Option decisions are some of the largest financial choices a family makes in a short window, and children usually see only the result: a new house, or a stock that went nowhere. A short note for each exercise (the price, why you exercised then, what tax you expected, what you would do differently) turns a one-time event 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

Are stock options taxed when they vest?

No. For both NSOs and ISOs, vesting only gives you the right to exercise. Nothing is taxed until you exercise (NSOs) or sell (ISOs), apart from possible AMT in the year of an ISO exercise. RSUs work differently: they are taxed as wages when the shares are delivered at vest, which is why people holding both often mix up the rules.

Do I owe tax if I exercise but do not sell?

For NSOs, yes. The spread is wages in the year you exercise, even if you keep every share, so you may need cash or a partial sale to cover the bill. For ISOs, there is no regular tax, but the spread counts for AMT if you still hold the shares on December 31, and at this income level that often creates a five or six figure bill.

What if the stock falls after I exercise ISOs?

If it falls in the same calendar year, selling before December 31 removes the AMT adjustment, and ordinary income is generally limited to your actual gain. If you hold into the next year, AMT is still based on the value at exercise. Part of it may come back later as a minimum tax credit on Form 8801, but slowly.

Next step

Before your next exercise, model the full bill (federal, state, AMT and payroll) and decide when each piece will be paid. For related decisions, see how a cashless exercise is taxed, drafting an 83(b) election if you early exercise, how tender offers work for private company shares, and why RSUs have no strike price. If you want the exercise plan built around your whole household, our tax management and concentration and risk work at Age Five Family Office™ starts with a Tax & Wealth Assessment.

This is general education, and 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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