By Kevin Luu, Co-Founder and Chief Learning Officer. Reviewed on 2026-09-30.
The difference between ISOs and NSOs is when the tax hits and what kind of tax it is. With a nonqualified stock option (NSO), the gap between the stock price and your exercise price is taxed as wages the day you exercise, with payroll withholding. With an incentive stock option (ISO), there is no regular income tax at exercise, and if you hold the shares long enough the whole gain is taxed later as a long-term capital gain, but the exercise can trigger the alternative minimum tax (AMT).
For a household earning $750,000 to $3 million, that difference can be worth tens of thousands of dollars on one exercise, and it decides which options you exercise first and how much cash you set aside.
Who actually has ISOs and NSOs
Public employers like Apple, Amazon and Gilead mostly pay equity in RSUs, which are taxed differently (see how RSUs are taxed). Options usually come from a spouse’s startup or pre-IPO job, an executive package, or an acquisition. Only employees can receive ISOs; non-employee advisors and board members receive NSOs. Your grant agreement says which kind you hold; one grant can mix both.
ISO vs NSO at a glance: grant, vest, exercise and sale
| Stage | NSO | ISO |
|---|---|---|
| Grant | No tax for a typical employee grant (no readily determinable value) | No tax |
| Vest | No tax (vesting only lets you exercise) | No tax |
| Exercise | Spread (price minus strike) taxed as wages: federal income tax, Medicare, Social Security up to the wage base, and state tax | No regular income tax. The spread is an AMT adjustment on Form 6251, line 2i |
| Withholding | Yes, through payroll. Shown on your W-2, box 12, code V | None at exercise. You receive Form 3921 instead |
| Sale | Growth after exercise is a capital gain, long-term if held more than one year after exercise | Qualifying sale: all gain over the strike is long-term capital gain. Early sale: spread becomes ordinary income |
How NSOs are taxed at exercise and sale
When you exercise an NSO, the spread is wages that year. Buy 5,000 shares at a $20 strike with the stock at $80 and you have $300,000 of wages, even if you never sell (Pub 525).
At this income level, three things follow:
- Federal income tax at 35% or 37%. For 2026, the married-filing-jointly 37% bracket starts at $768,700 of taxable income (Rev. Proc. 2025-32).
- Medicare, but usually not Social Security. Medicare is 1.45% with no cap, plus the 0.9% Additional Medicare Tax on joint wages above $250,000 (IRS). Social Security stops at the 2026 wage base of $184,500, which most families here pass on salary alone (Pub 15).
- Withholding that is usually too low. Employers typically withhold the 22% optional flat federal rate on supplemental wages, and must use 37% on supplemental wages above $1,000,000 in the calendar year (Pub 15, 2026).
Your cost basis in the shares is the strike you paid plus the spread taxed at exercise. For options granted on or after January 1, 2014, the 1099-B will not show that added basis, so it is corrected on Form 8949 at sale (Pub 525). Missing this step taxes the same spread twice. More in our page on NSO taxes.
How ISOs are taxed: the two holding periods
For regular tax, nothing is included in income when an ISO is granted or exercised (Pub 525). What happens next depends on how long you hold the shares.
- Qualifying disposition. You sell after the later of two years from the grant date and one year from the exercise date. The entire gain over your strike is long-term capital gain. For 2026, the 20% federal rate applies to joint taxable income above $613,700, and the 3.8% net investment income tax applies above $250,000 of modified AGI (Rev. Proc. 2025-32; IRS).
- Disqualifying disposition. You sell earlier. The spread at exercise becomes ordinary income, capped at your actual gain, and anything above it is capital gain. If you sell at a loss, there is no ordinary income (Pub 525).
ISO income is never subject to Social Security or Medicare tax, at exercise or at a disqualifying sale (IRC 3121(a)(22)), and no income tax withholding is required on a disqualifying disposition (IRC 421(b)). The tax is still owed, so you pay it through estimates or a larger April payment.
Three rules decide whether an option keeps ISO treatment. You must exercise within three months of leaving (one year if disabled) (Pub 525). The option must expire within ten years with a strike no lower than fair market value at grant (five years and 110% for owners of more than 10% of the company) (IRC 422(b) and (c)(5)). And the part of your ISOs that first becomes exercisable in one calendar year above $100,000 of stock, valued at the grant date, is treated as NSOs (IRC 422(d)).
Why ISOs trigger AMT, and how much room you have
For the AMT, the ISO spread at exercise is added to income as if it were taxed (Form 6251 instructions, line 2i). You then pay whichever is higher: regular tax or the tentative minimum tax. The tentative minimum tax is 26% of the taxable excess up to $244,500 and 28% above that for 2026, after an exemption of $140,200 for joint filers (Rev. Proc. 2025-32; IRC 55(b)).
The exemption is where this audience gets squeezed. For 2026 it shrinks by 50 cents for every dollar of AMT income above $1,000,000 and is gone at $1,280,400 (P.L. 119-21; Rev. Proc. 2025-32). A household whose AMT income falls between those two numbers loses exemption on every ISO dollar it adds. Inside that range, each added dollar of spread raises the taxable excess by $1.50, so at the 28% rate the effective AMT rate on that spread is 42%.
The AMT you pay because of ISOs is not lost. It becomes a minimum tax credit (Form 8801) that you can use in later years when regular tax is higher than tentative minimum tax, which often happens in the year you sell the shares. Keep records of both your regular and your higher AMT basis.
Worked example: the same exercise as NSOs and as ISOs
Assumptions, for illustration only: married filing jointly, $900,000 of combined salary, standard deduction, no other capital gains, itemized deductions and other AMT items ignored. In January 2026 the family exercises 5,000 options granted in 2024 at a $20 strike, equal to the stock’s value at grant ($100,000 of stock, within the ISO limit), with the stock now at $80. The spread is $300,000 and the cash to exercise is $100,000. They sell in February 2027 at $100, a total gain of $400,000. 2026 federal figures are used for both years because 2027 figures are not published. California uses 2025 brackets (2026 not published) on assumed California taxable income of $870,000 before the options.
| Tax item | As NSOs | As ISOs (qualifying sale) |
|---|---|---|
| Federal tax at exercise (2026) | $111,000 income tax (37%) + $7,050 Medicare (2.35%) = $118,050 | $76,604 AMT |
| Federal tax at sale (2027) | $23,800 on $100,000 long-term gain (20% + 3.8%) | $95,200 on $400,000 long-term gain (20% + 3.8%) |
| AMT credit used in the sale year | None | minus $76,604 |
| Total federal | $141,850 | $95,200 |
| California (income tax, 1% Behavioral Health Services Tax, SDI) | $35,385 + $3,900 SDI at exercise, $11,085 at sale = $50,370 | $47,685 at sale, plus any California AMT at exercise (not modeled) |
| Washington capital gains tax | $0 (gain below the deduction) | $8,540 (7% of $400,000 minus $278,000) |
| Total, California family | $192,220 | $142,885 |
| Total, Washington family | $141,850 | $103,740 |
How the AMT figure works: regular taxable income is $867,800, so regular tax is $243,251. AMT income is $1,200,000 ($900,000 plus the $300,000 spread). The exemption falls to $40,200, leaving a taxable excess of $1,159,800 and a tentative minimum tax of $319,854. The difference, $76,604, is the AMT. In 2027, the large regular-tax capital gain (basis $20) and the smaller AMT gain (AMT basis $80) leave regular tax about $95,000 above tentative minimum tax, so the full credit can come back that year, if income looks similar.
Four things stand out. The ISO saves about $46,650 of federal tax. In California, the state saving is small (about $2,700 before any California AMT) because California taxes capital gains as ordinary income. In Washington, the ISO actually creates a state tax the NSO avoided, because the whole $400,000 is a capital gain. And the ISO family needed $176,604 for the strike and the 2026 AMT, then held the stock a year with no certainty about the price. If the stock had dropped to $40 by December 2026 and they still held it, they would owe AMT on a $300,000 spread that no longer existed.
If the ISO family had sold in 2026 instead (a disqualifying sale at $100), federal tax would be $151,800 against $158,850 for the NSOs. The only difference is the Medicare tax, because ISO income is exempt from it.
California vs Washington: what changes for options
If you live in California
- NSO spread is taxed as wages. California’s flat supplemental withholding rate for bonuses and stock options is 10.23% for 2026 (EDD DE 44) and 1.3% SDI with no wage cap for 2026 (EDD).
- The top rate is 13.3% (12.3% plus the 1% Behavioral Health Services Tax above $1,000,000 of taxable income), and there is no lower rate for capital gains (FTB 2025 rate schedules; FTB). A qualifying ISO sale saves federal tax, not much California tax.
- California has its own AMT at 7.0% of the taxable excess, and the ISO spread is an adjustment there too (Schedule P (540), 2025). See our page on California AMT for families with ISOs.
- Moving does not erase California tax on options earned while you worked there. Option wage income (an NSO exercise or a disqualifying ISO sale) stays taxable by California after you move, but gain on shares sold after you move generally does not (FTB Pub 1100, 2025).
If you live in Washington
- There is no state income tax on an NSO exercise in 2026 (WA DOR).
- Long-term capital gains above the standard deduction ($278,000 for 2025, the latest published) are taxed at 7%, and 9.9% on taxable gains above $1,000,000 (WA DOR; DOR notice). Spreading a large ISO sale across tax years can keep more of the gain under the deduction.
- Washington has enacted a 9.9% income tax on AGI above $1,000,000 starting January 1, 2028 (WA DOR). A large NSO exercise in 2028 or later may no longer be state-tax-free.
Which to exercise first: ISOs or NSOs
These rules hold for most families:
- Deadlines first. Options close to expiration, or inside the three-month window after leaving a job, come before anything else.
- Exercise NSOs when you are ready to sell, or when the spread is small. Holding after an NSO exercise is the same as buying your employer’s stock with after-tax money. The tax on the spread is due either way.
- Exercise ISOs up to your AMT room, early in the calendar year. Your room is the spread you can add before tentative minimum tax passes regular tax. A January exercise gives you until December 31 to sell and wipe out the AMT if the price falls. See when to exercise ISOs.
- Use high-income years, with one exception. A bonus, RSU vest or NSO exercise is taxed at 35% or 37% for regular tax but 28% for the AMT, so it usually adds ISO room. Between $1,000,000 and $1,280,400 of AMT income (2026), the AMT rate is effectively 42%, so extra income shrinks the room.
- Keep concentration in view. Decide in advance how much of your net worth you will let ride on one stock, and at what price you will sell regardless of tax.
A cashless exercise sells shares the same day, so for ISOs it is a disqualifying disposition.
Early exercise and the 83(b) election (options only)
Some startups let you exercise options before they vest. You receive restricted shares that the company can buy back if you leave. The 83(b) election lets you be taxed on those shares when you receive them rather than when they vest. It must be filed with the IRS within 30 days of the transfer, by written statement or Form 15620 (Pub 525). This applies to restricted stock and early-exercised options, never to RSUs.
- Early-exercised NSOs. If you exercise when the stock value equals your strike and file an 83(b), the taxable spread is zero, and later growth can be capital gain. Without the election, the spread is taxed as wages at each vest.
- Early-exercised ISOs. Regular tax is unchanged. For the AMT, the election measures the spread at exercise instead of at vesting (Form 6251 instructions), which can be zero at a very early company. The one-year holding period begins the day after exercise (Pub 525).
- The trade-off. You pay the strike, and sometimes tax, for shares that may be forfeited or become worthless, and the election cannot be undone. An early-exercise feature can also make the whole grant count as exercisable in the grant year for the $100,000 ISO limit (Treas. Reg. 1.422-4(b)), so more of it may be NSOs than you expect.
Our guide to the 83(b) election covers the filing and the math.
Common mistakes with ISOs and NSOs
- Paying tax twice on NSO shares because the 1099-B basis was never corrected.
- Forgetting the AMT credit in later years, or losing the Form 3921 records behind the AMT basis.
What to document for your kids
Option decisions are among a family’s largest financial choices, and children never see them. A short Decision Memo in your FamilyKnowledge® Library can record what you held (grant dates, strikes, expirations, ISO and NSO split), what you chose and why (exercise now or wait, hold or sell, how much risk you accepted), what it cost in tax, and what you would do differently. Keep the Form 3921s and your AMT basis records with it. As Kevin Luu puts it: “Your kids don’t need to inherit your portfolio. They need to inherit your decision-making process.”
Decision checklist before you exercise
- Do I know which grants are ISOs and which are NSOs, and each expiration date?
- Have I modeled this year’s AMT room with my actual salary, bonus and RSU vests?
- Do I have cash for the strike and the tax, without selling other shares at a bad time?
- If the stock fell 50% after I exercise, could I live with the result?
- Will I sell before December 31 if the price drops, and who will watch for that?
- Have I written down why I am doing this, for my spouse and my kids?
Questions families ask about ISOs and NSOs
Is an ISO always better than an NSO?
No. An ISO only beats an NSO if you hold for a qualifying sale and the price holds up, and you may prepay AMT along the way. In Washington, a large qualifying sale can also bring the 7% capital gains tax. If you sell right away, federal tax on the two is almost the same, apart from Medicare tax.
What happens to my ISOs if I leave the company?
Your plan document sets how long you have to exercise vested options after you leave. To keep ISO tax treatment, you must exercise within three months of your last day as an employee. Options exercised later, even if the plan allows it, are taxed as NSOs, with the spread taxed as wages.
Do I owe AMT if I exercise ISOs and sell in the same year?
No. If you exercise and sell the shares in the same calendar year, no AMT adjustment is required. Instead, the spread (or your actual gain, if smaller) is ordinary income that your employer should report in box 1 of your W-2, without Social Security or Medicare tax and usually without withholding. Set aside cash or make an estimated payment, because the tax is still due by April.
Next step
List each grant as ISO or NSO with its expiration date, and estimate this year’s AMT room before you exercise anything. Our equity compensation page shows how options fit with RSUs, ESPP and the rest of your tax picture, and the Tax & Wealth Assessment offers a second set of eyes on the numbers. This is general education, and the right move depends on your family’s full picture.