Key Takeaways
- RSUs are taxed as ordinary income when they vest - no exercise required
- ISOs offer favorable tax treatment if you hold shares 2+ years from grant and 1+ year from exercise
- NSOs trigger ordinary income tax on the spread at exercise
- ISO exercises may trigger Alternative Minimum Tax (AMT)
- Holding period determines if gains are taxed as short-term or long-term capital gains
Complete Guide to Stock Options: RSUs, ISOs, and NSOs
Equity compensation has become a cornerstone of technology and startup employee compensation packages. Understanding the differences between Restricted Stock Units (RSUs), Incentive Stock Options (ISOs), and Non-Qualified Stock Options (NSOs) is essential for making informed financial decisions about your compensation. Each type has unique tax implications, exercise requirements, and strategic considerations.
This comprehensive guide explains how each equity type works, their tax treatments, optimal exercise strategies, and common mistakes to avoid. Use our calculator above to model your specific situation and understand the potential value of your equity compensation.
Restricted Stock Units (RSUs)
RSUs are the most straightforward form of equity compensation. They represent a promise from your employer to give you shares of company stock once certain conditions are met, typically vesting over time. Unlike stock options, RSUs have no exercise price and are always worth something as long as the stock has value.
How RSUs Work
When you receive an RSU grant, you are given a specific number of units that will convert to actual shares upon vesting. A typical vesting schedule is four years with a one-year cliff, meaning 25% vests after one year and the remaining 75% vests monthly or quarterly over the next three years.
At vesting, the shares become yours and the fair market value (FMV) at that moment is treated as ordinary income. Your employer will typically withhold taxes automatically, often through a sell-to-cover arrangement where some shares are sold to pay taxes.
RSU Tax Treatment
RSU taxation occurs at two points. First, at vesting, the FMV is taxed as ordinary income and appears on your W-2. This triggers income tax, Social Security tax (up to the wage base limit), and Medicare tax. Second, when you sell the shares, any gain or loss from the vesting price is treated as capital gains.
If you hold shares for more than one year after vesting before selling, gains qualify for long-term capital gains rates. If sold within a year, gains are short-term and taxed as ordinary income.
Incentive Stock Options (ISOs)
ISOs are stock options that qualify for special tax treatment under the Internal Revenue Code. They are only available to employees and offer potential tax advantages if specific holding requirements are met. However, they also carry Alternative Minimum Tax (AMT) implications that can catch unprepared option holders by surprise.
How ISOs Work
An ISO grant gives you the right to purchase company shares at a predetermined strike price, regardless of the current market price. Unlike RSUs, you must pay the strike price to acquire the shares (exercising the options). If the current stock price is below your strike price, the options are underwater and typically not worth exercising.
ISOs typically have a 10-year expiration and vest over time similar to RSUs. Once vested, you can exercise at any point before expiration. If you leave the company, you usually have 90 days to exercise vested options or they expire.
ISO Tax Treatment
ISOs offer preferential tax treatment if you meet qualifying disposition requirements: holding shares for at least two years from grant date AND one year from exercise date. If met, the entire gain from strike price to sale price is taxed as long-term capital gains.
AMT Warning
The spread at exercise (difference between FMV and strike price) is an AMT preference item. This can trigger AMT liability even though no regular tax is due at exercise. Many ISO holders have been surprised by substantial AMT bills, especially during rapid stock price appreciation. Consult a tax professional before exercising large ISO grants.
Disqualifying Dispositions
If you sell before meeting the holding requirements, it becomes a disqualifying disposition. The spread at exercise (or total gain if less) is taxed as ordinary income, with any additional gain taxed as capital gains. While this loses the ISO tax advantage, it also eliminates AMT concerns.
Non-Qualified Stock Options (NSOs)
NSOs are stock options without the special tax treatment of ISOs. They can be granted to employees, contractors, consultants, and board members. NSOs have simpler tax treatment but generally result in higher taxes than ISOs for qualifying dispositions.
How NSOs Work
NSOs function similarly to ISOs in that they grant the right to purchase shares at a strike price. They vest over time and must be exercised before expiration. The key differences are in tax treatment and who can receive them.
NSO Tax Treatment
At exercise, the spread between FMV and strike price is taxed as ordinary income. This appears on your W-2 and is subject to income tax and payroll taxes. Your employer is required to withhold taxes at exercise.
After exercise, any subsequent gain or loss from the exercise price to the sale price is treated as capital gains. The holding period for long-term treatment starts at exercise, so holding for more than one year qualifies for long-term rates.
Comparing RSUs, ISOs, and NSOs
| Feature | RSU | ISO | NSO |
|---|---|---|---|
| Exercise Required | No | Yes | Yes |
| Cash Outlay | None | Strike price | Strike price |
| Tax at Grant | None | None | None |
| Tax at Vest/Exercise | Ordinary income | AMT only (if applicable) | Ordinary income |
| LTCG Eligible | 1 year after vest | 2 years from grant + 1 year from exercise | 1 year after exercise |
| Who Can Receive | Anyone | Employees only | Anyone |
| Risk Level | Lower | Medium | Medium |
Exercise Strategies for Stock Options
Exercise and Hold
Exercising and holding the shares maximizes potential gains if the stock continues to rise. For ISOs, it starts the clock for qualifying disposition treatment. However, it requires cash to pay the strike price and ties up capital in a single stock position.
Exercise and Sell Immediately
A same-day sale exercises options and immediately sells the shares. No cash outlay is required since proceeds cover the exercise cost. For ISOs, this results in a disqualifying disposition but eliminates AMT concerns and market risk.
Exercise Over Time
Spreading exercises over multiple years can manage tax bracket and AMT impacts. This strategy works well when you have significant unrealized gains and want to control annual tax liability.
Pro Tip: 83(b) Election
For early exercise options or restricted stock (not RSUs), an 83(b) election can provide significant tax savings by electing to be taxed on the grant date value rather than the higher vesting date value. This election must be filed within 30 days and is irrevocable, so consult a tax professional.
Common Stock Option Mistakes
Letting Options Expire
Many employees lose valuable options by not exercising before expiration or within the post-termination exercise window. Track your expiration dates and exercise windows carefully.
ISO AMT Surprise
Exercising ISOs without understanding AMT can result in large unexpected tax bills. Before exercising substantial ISO grants, calculate your potential AMT liability or consult a tax professional.
Concentration Risk
Holding too much wealth in a single stock is risky. Many employees lost significant wealth when their company stock declined substantially. Consider diversifying as shares vest or as you exercise options.
Planning for Your Equity Compensation
Managing equity compensation effectively requires understanding your grant terms, tax implications, and personal financial situation. Key steps include reviewing grant documents thoroughly, understanding vesting schedules, tracking expiration dates, estimating tax liability, and consulting with tax and financial professionals for significant grants.
Use our calculator to model different scenarios and understand how various exercise and sale strategies affect your net proceeds. Remember that stock prices can decline, and equity compensation carries risk that should be factored into your overall financial plan.