ISO vs NSO: The Tax Implications

Tax rules vary between incentive stock options (ISO) and non-qualified stock options (NSO). You need to know the rules when assessing ISO vs NSO.

Employee stock options are increasingly popular, especially among startups that want to attract top talent. Rather than offering higher salaries, companies use stock options to supplement an employee’s compensation. This serves as a financial benefit to employees and helps companies retain top talent.

There are two main types of stock options: incentive stock options (ISOs) and non-qualified stock options (NSOs). Both are subject to different tax rules. Knowing the difference is an essential part of your financial planning.

Let’s level set.

What are incentive stock options (ISO)?

Incentive Stock Options (ISOs) are employee stock options that come with tax advantages. They allow employees to potentially pay lower capital gains tax rates when selling the stock, provided certain conditions are met. ISOs are designed to align employee interests with the company’s performance, offering a stake in its growth.

How do incentive stock options work?

Let’s assume an executive is granted $200,000 worth of ISOs with an exercise price of $50 per share. The grant allows the executive to purchase 4,000 shares ($200,000 / $50 per share). The executive then exercises the options when the stock price has risen to $75 per share. Since ISOs offer tax advantages, the $25 per share appreciation may be subject to capital gains tax upon sale. To qualify for favorable tax treatment, the executive typically needs to hold the shares
for at least one year from the exercise date and two years from the grant date. Any subsequent gain may be taxed at the more favorable long-term capital gains rates if these conditions are met.

What are non-qualified stock options?

Non-Qualified Stock Options (NSOs) are stock options for employees without special tax benefits. The difference between the exercise price and the stock value is taxed as ordinary income. NSOs offer flexibility in design and are transferable. Individuals should review terms and consult professionals for guidance.

How do non-qualified stock options work?

Non-Qualified Stock Options (NSOs) give employees the right to buy company stock at a set price. The options may vest over time. When employees exercise NSOs, the price difference is taxed as ordinary income. After exercise, employees can hold or sell the shares, with any subsequent gains or losses subject to capital gains tax. NSOs are often transferable. Understanding the terms, including vesting and tax implications, is important, and I recommend consulting with a professional.

When’s the best time to exercise NSOs?

Generally, employees may choose to exercise when the stock price is low to minimize the exercise cost. Unlike ISOs, NSOs don’t have the same tax advantages, and the difference between the exercise price and the fair market value at exercise is subject to ordinary income tax. Personal financial circumstances, market conditions, and tax implications should guide the decision on when to exercise NSOs and assess ISO vs NSO choices.

ISO vs NSO: The tax implications

Incentive stock options are reserved for employees, offering them an opportunity to buy stock at a discounted price. What’s more, ISOs are subject to the capital gains tax rate. However, the preferential tax treatment is subject to specific disposition timelines. Employees granted the right to purchase stocks must wait until shares fully vest before exercising their options.

Non-qualified stock options may go to employees, company partners, vendors, or others who aren’t on the company payroll. These stocks function like ISOs, except you pay taxes on the spread between the grant and exercise prices at your standard income tax rate. As with ISOs, employees must wait until shares vest before they can exercise their options. NSO taxes are withheld at the time of exercise.

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What is the tax treatment of ISOs?

Because employees with ISOs don’t need to pay taxes immediately upon exercising their options, ISOs are generally more tax-advantaged than NSOs. Those exercising ISOs only pay taxes when they sell their shares. If an employee keeps the shares until at least one full year after vesting and at least two years after the grant date, the gains qualify as capital gains instead of ordinary income. The good news is that ordinary or capital gains taxes aren’t due on ISOs until you file your taxes for the calendar year in which they’re sold.

For example, let’s say you’re granted 100 shares of incentive stock options on January 1, 2023, and the shares vest on January 1, 2024. If you exercise and hold the options on January 1, 2024, you will have to hold the shares for at least one year to qualify for the preferential capital gain tax treatment.

Capital gains tax rates vary depending on your taxable income. As of 2024, the capital gains tax rates are as follows:

The biggest risk with ISOs is the potential for the stocks to lose value before they can be sold, especially if you are subject to the AMT (alternative minimum tax) in the year that you exercise. If you sell them before waiting a full year after vesting (otherwise known as a disqualifying disposition), then you lose the long-term capital gains tax benefit that makes them so attractive in the first place.

What is the tax treatment of NSOs?

NSOs are different. Regardless of whether you hold your stock options or sell them, the spread (the difference between the exercise price and grant price) is counted as part of your earned income and taxed at your ordinary income rate. NSO taxes are withheld at the time of exercise.

This earned income is also subject to payroll taxes, which include Social Security and Medicare. Social Security payroll taxes are equal to 6.2 percent on earnings up to $137,700. If your earned income already exceeds this amount, then you’ll only pay taxes toward Medicare, which is 1.45 percent. However, if your earned income doesn’t exceed this amount, your gains will be subject to your ordinary income tax rate plus 7.65 percent to account for payroll taxes.

Does AMT Affect ISO vs NSO?

The AMT can take away some of the financial cushion of ISOs. If you hold onto your ISOs, you will need to report the difference between the grant price and exercise price as part of your alternative minimum taxable income. AMT is a critical component in working through an ISO exercise and hold strategy. Insiders of publicly traded companies may need to hold onto the stock after it has lost significant value. By the time you may be able to sell the shares, they could be worth less than the AMT tax due on the original exercise. Careful planning with a team of financial experts can help individuals avoid the AMT trap and establish a robust tax and trading strategy.

How to plan for employee stock tax implications

Regardless of whether you receive incentive stock options or non-qualified stock options, know that both are subject to taxes and need to be accounted for when you file. The most important thing to remember is that once you exercise your options, the result is the same—you now own stock in the company, and that stock can help you pad your financial future beyond your regular paycheck.

To make the most of your employee stock options, it’s best to consult with a CERTIFIED FINANCIAL PLANNER™ who can help you navigate the complexities of stocks and tax laws to maximize your returns and minimize your costs.

Read more from our blog:

• Exercising Stock Options? What You Need to Know About the Alternative Minimum Tax
• Employee Stock Options: How They Work and What to Expect
• How One Executive Channeled Complex Compensation to Grow Wealth
• Everything You Need to Know About Vesting Schedules

The information contained in this document is provided for informational purposes only and should not be construed as individualized advice. For individualized advice, please consult with your adviser.