By Kevin Luu, Co-Founder and Chief Learning Officer. Reviewed on 2026-09-30.
An ISO exercise costs no regular income tax on the day you buy the shares, but the spread between the stock’s fair market value and your strike price counts as income for the alternative minimum tax (AMT). If you hold the shares at least two years from grant and one year from exercise, the whole gain is taxed later as a long-term capital gain. Sell earlier and the spread becomes ordinary income instead.
So the real question is not whether to exercise. It is how much to exercise each year before the AMT starts, and whether you can afford to hold. In the worked example below, a California family with $900,000 of wages starts owing federal AMT after roughly $145,000 of spread in 2026; your own threshold depends on your income and deductions. This page shows the math, how California and Washington differ, how to get AMT back through the credit, and what to write down for your kids.
Who holds ISOs in a high-income family
Incentive stock options are mostly granted by startups and private companies. Large employers such as Apple, Amazon, Gilead and Genentech grant most equity as RSUs rather than ISOs, and RSUs are taxed as wages at vest (see how RSUs are taxed). In the families we work with, ISOs usually arrive when one spouse joins a pre-IPO biotech or software company while the other stays on a large-company salary. That mix matters: the big W-2 income sets your regular tax, and the regular tax sets how much ISO spread you can absorb before AMT applies.
ISOs differ from nonqualified options (NSOs). An NSO exercise is taxed as wages right away, with withholding. An ISO exercise has no withholding and no regular tax, but it does have the AMT and the holding-period rules below. For the side-by-side, see ISO vs NSO for California and Washington families.
How an ISO exercise triggers the AMT
The AMT is a second tax calculation that runs alongside your regular return on Form 6251. You pay whichever is higher. The ISO spread at exercise (fair market value minus strike, times shares) is an AMT adjustment: it is added to AMT income even though it is not regular income (IRS Publication 525). Your employer reports the exercise on Form 3921 after year end.
The 2026 federal AMT numbers for married couples filing jointly (Rev. Proc. 2025-32):
- Exemption: $140,200.
- The exemption shrinks by 50 cents for every dollar of AMT income over $1,000,000 and is gone at $1,280,400. The faster 50% phase-out comes from the 2025 tax law (P.L. 119-21).
- Rates: 26% on the first $244,500 of AMT income above the exemption, 28% above that (IRC section 55).
Two details explain why a $900,000 household is usually not in AMT until it exercises. First, regular tax on high income climbs to a 37% marginal rate, while the AMT rate tops out at 28% outside the phase-out band, so regular tax usually runs ahead of the AMT calculation. Second, state and local tax is not deductible for AMT, but with the 2026 SALT deduction at its $10,000 floor for incomes over about $606,333, that add-back is small. The cushion is the gap between your regular tax and your tentative minimum tax. We call it AMT room, and the ISO spread fills it at 28 cents per dollar.
Inside the phase-out band ($1,000,000 to $1,280,400 of AMT income), each extra dollar of spread also removes 50 cents of exemption, so the effective AMT rate is 42% (28% times 1.5). That band is where large exercises get expensive fast. For a step-by-step calculation, see how AMT is calculated and what tentative minimum tax means.
Worked example: a $900,000 California household exercising ISOs in 2026
Assumptions (illustrative): married filing jointly, $900,000 of W-2 wages and no other income. One spouse holds ISOs with a $5 strike; the latest 409A value is $25, so each share carries $20 of spread. After the 2026 limits, itemized deductions are $52,500 for regular tax ($10,000 of state and local tax, $30,000 of mortgage interest and $20,000 of charitable gifts, trimmed by the new 0.5%-of-income floor on charity and the 2026 limit on itemized deductions in the 37% bracket). That gives taxable income of $847,500 and regular federal tax of $235,739.50. For AMT, the $10,000 of state tax is added back and the 2026 itemized-deduction reduction for the 37% bracket does not apply, so AMT income before any exercise is $854,500.
California runs its own AMT at 7% on Schedule P (540). For the California columns we simplify to $900,000 of California taxable income and $20,000 of other AMT adjustments, using the 2025 Schedule P figures, because the Franchise Tax Board has not published 2026 amounts (FTB Schedule P instructions). California regular tax on $900,000 is about $78,232 (2025 rates).
| Shares exercised | ISO spread | Cash for strike | Federal AMT (2026) | California AMT (2025 figures) |
|---|---|---|---|---|
| 0 | $0 | $0 | $0 (room about $40,600) | $0 |
| 7,250 | $145,000 | $36,250 | $0 | $0 |
| 15,000 | $300,000 | $75,000 | About $65,000 | About $7,200 |
| 25,000 | $500,000 | $125,000 | About $138,600 | About $21,200 |
What the table says. This family can exercise about 7,250 shares in 2026 for $36,250 of cash and owe no AMT at either level. California’s AMT room is larger (about $197,600 of spread in this setup), so the federal limit binds first. Going to 15,000 shares costs $75,000 for the strike plus about $72,200 of combined AMT, or roughly $147,000 of cash for shares that cannot yet be sold. At 25,000 shares, AMT income passes $1,280,400, the exemption is gone, and the federal AMT alone is close to $139,000.
Splitting exercises across tax years is the main lever. The same 15,000 shares, exercised as 7,250 in December and the rest in January, can land with little or no AMT in either year, as long as income and the 409A value stay similar.
Getting AMT back: the minimum tax credit
AMT paid because of an ISO exercise is not lost. It becomes a minimum tax credit, claimed on Form 8801, that carries forward to later years. You can use it in any year your regular tax is higher than your tentative minimum tax, up to that gap.
In the example above, the family that exercised 15,000 shares carries about $65,000 of federal credit into 2027. If income and deductions stay the same and they do not exercise again, their annual room is about $40,600, so they would recover about $40,600 in 2027 and the remaining $24,400 in 2028. The year they sell the shares, recovery usually speeds up: their AMT basis is $25 a share (the value at exercise) while their regular basis is $5, so the sale creates a negative AMT adjustment that widens the gap.
Three things slow recovery. More ISO exercises use up the room the credit needs. Higher income inside the federal AMT phase-out band shrinks the gap. And if the stock never becomes sellable, the credit can sit unused for years. California has a similar credit for prior-year AMT, claimed on form FTB 3510 (FTB Schedule P instructions).
Disqualifying dispositions: when selling early is the better choice
A disqualifying disposition is any sale before both holding periods are met (two years from grant, one year from exercise). The spread at exercise, or your actual gain if smaller, becomes ordinary income, usually reported on your W-2 with no Social Security or Medicare tax (Publication 525; IRC section 3121(a)(22)). Any gain above that is a capital gain.
Selling early is sometimes the right call:
- Same-year sale wipes out the AMT. If you exercise and sell in the same calendar year, the AMT adjustment for those shares generally goes away and the income is treated as compensation (Form 6251 instructions).
- The stock fell after exercise. If the price drops below your exercise-date value before December 31, a disqualifying sale limits ordinary income to the actual gain. Holding into January can leave you owing AMT on a spread that no longer exists.
- You need the cash. A partial sale to cover strike and tax costs is often cheaper than borrowing against illiquid shares.
The cost of selling early is the lost long-term rate. Keep the example family’s 15,000 shares and assume they later sell at $35, a $450,000 total gain. Held long enough, the federal tax is 20% plus 3.8% net investment income tax, about $107,100. Sold early, within a year of exercise, $300,000 is ordinary income at 37% ($111,000) and $150,000 is a short-term gain at 37% plus 3.8% ($61,200), about $172,200. The federal difference is about $65,100.
California vs Washington: how the ISO decision changes
| Question | California | Washington |
|---|---|---|
| State tax at exercise | Possible state AMT at 7% (2025 Schedule P) | None. No state income tax or AMT in 2026 |
| State tax on a qualifying sale | Whole gain taxed as ordinary income, up to 13.3% (2025); no lower rate for capital gains | 7% capital gains tax on long-term gains above the standard deduction ($278,000 for 2025, latest published); 9.9% above $1,000,000 of taxable gains |
| State tax on a disqualifying sale | Same ordinary rates as a qualifying sale | The compensation part is not a capital gain; a short-term gain is not subject to the capital gains tax |
| What holding buys you | Federal savings only (about $65,100 in the example) | Federal savings minus Washington capital gains tax (about $12,000 in the example, if no other gains) |
In California the state takes the same bite whether you hold or sell, because California has no lower rate for capital gains. The ISO holding decision is a federal decision, plus a 7% state AMT check at exercise. For more on the state side, see California AMT for families with ISOs.
In Washington there is no state tax at exercise, but a qualifying sale can trigger the state capital gains tax. In the example, $450,000 of long-term gain minus the $278,000 deduction (the 2025 amount; Washington adjusts it for inflation each year) leaves $172,000 taxed at 7%, about $12,040. Holding still wins, by a smaller margin. Washington also enacted a 9.9% income tax, starting January 1, 2028, for individuals and married couples filing jointly with adjusted gross income over $1 million (WA Department of Revenue). A family planning a large sale for 2028 or later should model that before choosing the year.
When to exercise ISOs: timing rules that matter
- Exercise early in the year. A January exercise starts the one-year clock and gives you until December 31 to decide whether a same-year sale makes sense if the price drops.
- Use the AMT room every year. Exercising up to the room each year spreads the cost and starts more holding periods sooner.
- Exercise while the 409A value is low. Before an IPO, the spread is often smaller, so the same shares use less AMT room. The trade-off is buying shares you cannot sell.
- Watch the $100,000 limit. If the ISOs that first become exercisable in one calendar year cover more than $100,000 of stock, valued at fair market value on the grant date, the options above that amount are treated as NSOs (IRC section 422(d)).
- Know your leaving deadline. To keep ISO treatment, you generally must exercise within three months after you stop being an employee, or one year if you leave because of disability. An option exercised later is taxed as a nonqualified option (Publication 525). Many plans also end the options at that point, and a plan that gives you longer does not extend the ISO deadline.
- Consider early exercise. If your plan lets you exercise unvested options, the shares you receive are restricted stock. An 83(b) election on those shares, filed within 30 days of the exercise, measures the AMT spread on the exercise date instead of at vesting, which keeps it small if you exercise soon after grant. The election covers the shares, not the option itself (Publication 525). See the 83(b) election for pre-IPO families.
- Pay estimated tax. No tax is withheld on an ISO exercise. If last year’s adjusted gross income was over $150,000, paying 110% of last year’s tax through withholding and estimates generally avoids an underpayment penalty (IRS Publication 505).
Decision checklist before you exercise
- Pull your grant documents: strike price, vesting, expiration date and whether early exercise is allowed.
- Get the current 409A or market value and calculate the spread per share.
- Estimate this year’s AMT room, federal and California, with your current income and deductions.
- Decide how much cash you can put into shares you may not sell for a year or more, including AMT.
- Cap the position. Decide what share of your net worth one private company should be.
- Pick the year. Compare exercising this December, next January or both.
- Write down your sale plan: the price or date at which you would sell, and what would make you sell early.
- Set up estimated payments and track AMT basis separately from regular basis.
What to document for your kids
Your kids will not remember the exercise. They may remember the year you didn’t take the vacation because cash was tied up in stock, or the year the company went public. What they will not see is the reasoning: why you exercised 7,250 shares and not 25,000, how much risk you were willing to take on one company, and what you planned to do if it failed.
A short Decision Memo after each exercise covers it: the numbers, the trade-off, what you decided and why, and how it turned out. Filed in your FamilyKnowledge® Library, it becomes a real lesson in risk, patience and taxes, written by the people your children trust most. As Kevin Luu, Co-Founder and Chief Learning Officer of Bright Advisers, puts it: “Your kids will inherit your money. Will they inherit your judgment?”
Questions families ask about ISO exercises
Do I owe AMT if I exercise and sell ISOs on the same day?
Generally no. Exercising and selling in the same calendar year is a disqualifying disposition, so the AMT adjustment for those shares goes away. The spread is taxed as ordinary income, usually on your W-2, at your regular rate, without Social Security or Medicare tax. You give up the long-term capital gains rate but avoid holding risk and AMT.
Is tax withheld when I exercise ISOs?
No. Employers do not withhold income tax or payroll tax on an ISO exercise, even when the spread is large. If the exercise creates AMT, you pay it through estimated payments or extra withholding from salary. A disqualifying sale later in the year can also leave a balance due, because the ordinary income has no withholding attached.
What happens to AMT I paid if the company never goes public?
The minimum tax credit stays available and carries forward, but you can only use it in years your regular tax exceeds your tentative minimum tax. If the shares become worthless, you may claim a capital loss for what you paid to exercise. The AMT itself is recovered only through the credit, which can take years. That risk is why many families cap exercises at the AMT room.
Should I exercise ISOs before an IPO?
It can make sense when the spread is small, because the AMT cost is low and the holding clock starts early. The risk is putting cash into shares you cannot sell, with no certainty of an IPO. Many families exercise only up to the AMT room each year and keep the rest of their net worth diversified. Our guide to how ISOs are taxed covers the stages in more detail.
Next step
Gather your grant agreement, the latest 409A value and last year’s return, and estimate your 2026 AMT room with the table above. The equity compensation page explains how ISOs fit with RSUs, ESPP and the rest of a family’s plan, and the Tax & Wealth Assessment is there if you want a second set of eyes on the numbers before you exercise. This is general education, and the right move depends on your family’s full picture.