ISO vs NSO stock options: taxes and AMT

ISOs and NSOs side by side

A stock option is the right to buy company shares at a fixed price, the strike (or exercise) price, usually the share price on the day of the grant. When you exercise, you pay the strike and get shares worth more; that difference is the spread. The tax law treats the two kinds very differently:

ISO rules from IRC 421 and 422 and IRS Publication 525. Plans can be stricter than the law, for example with a shorter window to exercise after you leave.

ISOs carry other conditions too: a shareholder-approved plan, a strike price at least the share value at grant, a term of at most 10 years, and no transfers except at death. For someone owning more than 10% of the company the strike must be at least 110% of value and the term 5 years. The $100,000 limit counts the value at grant of the shares whose options first vest in a year, so a large grant often arrives as part ISOs and part NSOs.

Exercising NSOs: the spread is pay

Take 2,000 options with a $10 strike price when the shares trade at $50, granted in March 2024 and exercised in March 2026, by a single filer in Texas (no state income tax) earning $150,000. As NSOs, the $80,000 spread goes on their W-2 as wages:

Withholding at exercise from the stock option engine; the tax added is the federal return with the spread minus without it, including the 0.9% Additional Medicare tax on wages over $200,000.

The flat 22% is the IRS rate for supplemental wages (37% on any over $1 million a year), not this person's bracket. The spread pushes their top rate from 24% to 32%, so the tax it adds averages 25.6%. Social Security is withheld on the whole spread at exercise, but it stops at the $184,500 wage base, so over the year it rises by only about $2,139. In a sell-to-cover (cashless) exercise, the broker sells 875 shares, about $43,750, to pay the strike and the withholding. Your basis in the shares you keep is the $50 market price at exercise, so a later sale is taxed only on the change from there. The same withholding gap shows up with RSUs; see how RSUs are taxed and the RSU calculator.

Exercising ISOs: the alternative minimum tax

The AMT is a second way of figuring your tax, with fewer deductions and two flat rates. You pay whichever is higher; the excess over your regular tax is the AMT. For 2026, AMT income above an exemption of $90,100 (single) or $140,200 (married filing jointly) is taxed at 26%, and 28% on the part more than $244,500 above the exemption. The exemption shrinks by 50 cents for each dollar of AMT income over $500,000 (single) or $1,000,000 (joint). The standard deduction does not count for the AMT, and an ISO spread on shares still held at year end is added in (Form 6251, line 2i).

Most people with only wages owe no AMT: the $150,000 earner in our example has a regular tax of $24,734 and a tentative minimum tax of just $15,574. The $9,160 gap between them leaves room for about $35,200 of ISO spread, taxed at 26% for the AMT, before any AMT is due. Exercising and holding all 2,000 ISOs uses that up and adds $11,640 of AMT, no Social Security or Medicare, and no withholding. Here is the federal AMT at several sizes, with the same $40 spread per share:

Single filer, $150,000 salary, standard deduction, 2026. The California column is the extra state AMT the same exercise adds for a California resident at 7%, using the 2025 Schedule P exemption ($92,749 single) until the 2026 figure is published.

The AMT-free amount for this person is 880 options, $35,200 of spread; option number 881 adds the first $2.40. Past that, each extra dollar of spread costs 26 cents, then 28 cents (more where the exemption phases out). California has its own AMT at a flat 7%. For a California resident with the same salary, the federal AMT is the same and the state AMT starts later, at about 2,040 options ($81,600 of spread), reaching $18,827 at 8,000 options. The calculator checks both.

The AMT credit comes back later

AMT from an ISO exercise is mostly a prepayment. Because an ISO spread is a timing difference (the same gain is taxed for regular tax when you sell), the AMT it causes becomes a minimum tax credit, claimed on Form 8801 in later years. Each year you can use it up to the amount by which your regular tax exceeds your tentative minimum tax; the rest carries forward with no time limit. For our $150,000 earner in a normal year that room is about $9,160, so the $11,640 from exercising 2,000 ISOs would take about 2 years to recover. The year you sell the shares usually speeds it up: your AMT basis includes the spread you already counted, so the AMT gain is smaller than the regular gain. The income tax calculator has an ISO spread field that shows the AMT on a full return.

Selling ISO shares: qualifying or not

A sale is qualifying if it comes more than 2 years after the grant and more than 1 year after exercise. For options granted March 1, 2024 and exercised March 2, 2026, that is Mar 3, 2027 or later. Anything sooner is a disqualifying disposition: the spread at exercise (but never more than your actual gain) becomes wages on your W-2, with no withholding and no Social Security or Medicare, and the rest is a capital gain. Selling in the same year you exercise also removes the AMT adjustment. Here are 1,000 of the options, exercised at $50:

Federal tax for a single filer in Texas earning $150,000. Short-term gains are taxed like wages; the qualifying sale is all long-term gain at 15%.

A same-day sale taxes the $40,000 spread like a bonus. If the price climbs to $60 before the sale, the first $40,000 is still ordinary income and only $10,000 is a short-term gain. If it falls to $30, the ordinary income shrinks to the $20,000 actually gained. Wait for Mar 3, 2027 and the same $60 sale is a $50,000 long-term gain, taxed $7,500 instead of $12,000.

Strategies, and the risk of holding

• Exercise and sell. No cash needed and no AMT, but the spread is taxed like pay. On 1,000 options this person keeps $30,400.
• Exercise and hold. They pay the $10,000 strike and $1,240 of AMT up front ($11,240 in all). If the price is still $50 at the qualifying date, they keep $34,000, assuming the AMT comes back as a credit. If it has fallen to $20, they keep $8,500.
• Exercise early in the year, not in December. An early exercise starts the one-year clock sooner and leaves time to sell before December 31 if the price drops, which turns the exercise into a disqualifying sale taxed on the lower actual gain and erases the AMT. A December exercise gives up that escape, though you know your income for the year better.
• Spread exercises over several years to use the AMT-free room and the 26% rate each year, as below.

6,000 ISOs with a $40 spread, exercised in equal parts at the same price each year; the same $150,000 single filer. Most of the AMT returns later as a credit; spreading mainly cuts how much is paid up front.

At the AMT-free pace of 880 a year it would take 7 years, and the price will not stand still. The real danger is paying AMT on shares that later fall. Exercise and hold 5,000 ISOs and this person pays $50,000 for the shares plus $43,148 of AMT. If the price then drops to $15 in a later year, the shares are worth $75,000, less than the cash put in, and the AMT credit trickles back at roughly $9,160 a year. ESPP shares follow similar holding rules without the AMT; see how ESPP is taxed.

What this guide does not cover

• Early exercise and 83(b) elections. Some private companies let you exercise before options vest and file an 83(b) election within 30 days, which changes when the spread is counted.
• Private-company valuation. Without a market price, the spread is based on the company's fair market value (often a 409A valuation), and selling the shares may not be possible for years.
• Other AMT items such as private activity bond interest, and the AMT on itemized state and local taxes, which can shrink your AMT-free room.