Equity compensation
What are stock options? How do they work? Stock options explained
An employee stock option is a contract from your employer giving you the right, but not the obligation, to buy a set number of company shares at a fixed price for a fixed period. If the shares end up worth more than that price, the option has value; if not, you let it expire and lose nothing but the opportunity. That is the whole idea. The complications come from the two tax flavors options come in, from the vocabulary, and from the fact that the word "option" also describes a different financial product traded on exchanges. This guide covers all of it, with worked numbers.
The two types of employee stock options
Employee options are either incentive stock options (ISOs) or non-qualified stock options (NSOs), sometimes written NQSOs. The economics are identical: same strike, same vesting, same expiration. The difference is purely tax.
- ISOs are defined in Internal Revenue Code section 422. If the rules are followed, you owe no regular income tax when you exercise, and the entire gain from strike price to sale price is a long-term capital gain. The rules: the strike must be at least fair market value at grant, the option term cannot exceed 10 years, you must still be employed (or have left within the last three months) when you exercise, you must hold the shares at least two years from grant and one year from exercise, and no more than $100,000 of options (valued at grant) can first become exercisable in any calendar year. ISOs can only be granted to employees. The price of the favorable treatment is exposure to the alternative minimum tax at exercise.
- NSOs are everything else: options granted to contractors or directors, options above the $100,000 limit, ISOs exercised too late after leaving. When you exercise an NSO, the spread between the share value and your strike is ordinary wage income, reported on your W-2 in box 12 with code V (IRS Publication 525), with federal income tax withheld at the 22% supplemental rate, or 37% once supplemental wages exceed $1 million in the year (IRS Publication 15). Any further gain after exercise is capital gain.
Your grant notice states which type you hold. A single grant is often split into both because of the $100,000 rule.
How they differ from exchange-traded options and RSUs
Exchange-traded options
The call options you can buy in a brokerage account are standardized contracts between unrelated investors, traded on exchanges, priced by the market and freely resold. Employee options are a private contract with your employer: you did not pay for them, you cannot sell or transfer them, they vest over years rather than trading immediately, their value is only realized by exercising, and they typically last far longer. The only thing the two share is the payoff shape.
Restricted stock units
An RSU is a promise to deliver whole shares once vesting conditions are met; there is no strike price and nothing to buy. An RSU is therefore worth something at any share price above zero, while an option is worth nothing unless the stock rises above the strike. RSUs are taxed as wages on their full value at vest, as described in our RSU tax guide and illustrated by Amazon's RSU schedule; you can model a vest with the RSU tax calculator. Employee stock purchase plans are a third thing again, a discounted purchase program with its own rules (see the ESPP calculator).
Grant, strike, vesting, exercise, expiration
- Grant. The company awards you a number of options at a strike price (also called the exercise price), normally the fair market value on the grant date. For a public company that is the market price; for a private company it is the 409A appraisal value, which our private company equity guide explains. Nothing is taxable at grant.
- Vesting. You earn the right to exercise over time. A typical schedule is four years with a one-year "cliff": nothing vests for 12 months, then 25% at once, then the rest monthly or quarterly. Unvested options are forfeited if you leave.
- Exercise. You pay the strike price and receive shares. The difference between the share price and the strike on that day is the bargain element or spread, and it is the number the tax rules care about. For an ISO exercise the company must send you Form 3921 showing the dates, strike, fair market value and share count.
- Expiration. Options have a hard end date, 10 years from grant at most for ISOs under section 422(b)(3). Leaving the company shortens it: most plans give you a window, commonly 90 days, to exercise vested options or lose them. Options that expire unexercised are worth nothing, however high the stock went in between.
The payoff at any moment is simple arithmetic: (share price minus strike) times the number of vested options, floored at zero. Options with a strike above the current price are "underwater" and have no exercise value, although they may regain it later.
How each type is taxed, with a worked example
Assumptions: 1,000 options with a $10 strike, exercised when the stock is $30, shares sold at $45. The filer is in the 32% federal bracket for ordinary income and the 15% bracket for long-term gains; in 2026 the 15% rate runs from $49,450 to $545,500 of taxable income for single filers (Rev. Proc. 2025-32). State tax, the 3.8% net investment income tax and any AMT actually payable are left out to keep the comparison clean.
| Scenario | At exercise | At sale | Total federal tax |
|---|---|---|---|
| NSO, sold more than 1 year after exercise | $20,000 wages; tax $6,400 (only $4,400 withheld at 22%) | $15,000 long-term gain; tax $2,250 | $8,650 |
| ISO, holding periods met (qualifying disposition) | $0 regular tax; $20,000 AMT adjustment | $35,000 long-term gain; tax $5,250 | $5,250 plus any AMT, which is later creditable |
| ISO, sold at $45 within 1 year of exercise (disqualifying) | None | $20,000 wages ($6,400) plus $15,000 short-term gain ($4,800) | $11,200 |
| ISO, exercised and sold same day at $30 (cashless) | None | $20,000 wages; tax $6,400; no AMT | $6,400 |
Three things stand out. The NSO holder's $2,000 withholding shortfall is the same gap that catches RSU recipients. The qualifying ISO holder pays the least, but only by taking on AMT exposure at exercise; whether any AMT is actually due depends on the spread and your other income, and the 2026 exemption of $90,100 single or $140,200 joint (Rev. Proc. 2025-32) shields a lot of smaller exercises. Use the ISO AMT calculator before exercising. And the disqualifying ISO sale is taxed like an NSO, except that under section 421(b) nothing is withheld and under section 3121(a)(22) no Social Security or Medicare tax applies.
In every case your cost basis in the shares includes any amount already taxed as wages. Brokers' 1099-B forms frequently omit that, so check the basis before filing or you will be taxed on the spread twice.
The four ways to exercise
| Method | How it works | Cash needed | Shares kept | Tax note |
|---|---|---|---|---|
| Cash exercise | You pay the strike (and NSO withholding) from your own funds | Full strike price | All | Only method that preserves ISO treatment on every share |
| Cashless (same-day sale) | Broker sells all shares immediately and nets out the strike | None | None | For ISOs, a disqualifying disposition; no AMT |
| Sell-to-cover | Broker sells just enough shares to pay the strike and tax | None | Most | Sold ISO shares are disqualified; kept shares start the holding clock |
| Net exercise | Company withholds shares equal in value to the strike instead of selling | None | Most | Common for NSOs; plan-dependent, rarely offered for ISOs |
Which method is available depends on your plan and, for private companies, on whether any buyer exists. The trade-offs for ISOs are laid out in detail in our guide to cashless ISO exercises.
When options are worth more than RSUs, and when they are not
Companies that offer a choice usually set an exchange ratio, often three or four options per RSU, because an option is worth less than a share. The option wins only if the stock rises enough. A simple comparison: 4,000 options with a $50 strike against 1,000 RSUs, both fully vested.
| Share price | Value of 4,000 options | Value of 1,000 RSUs | Better |
|---|---|---|---|
| $30 | $0 | $30,000 | RSUs |
| $50 | $0 | $50,000 | RSUs |
| $66.67 | $66,680 | $66,670 | Break-even |
| $80 | $120,000 | $80,000 | Options |
| $100 | $200,000 | $100,000 | Options |
At a 4:1 ratio the stock has to rise a third before options pull ahead, and below the strike they are worth nothing while RSUs still pay. Options therefore suit people who are confident in the company, early in their careers, and able to absorb a zero outcome. RSUs suit people who want compensation they can count on. Taxes tilt the comparison slightly toward options: RSUs are taxed in full at vest whether you want the shares or not, while options let you choose when to recognize income, and ISOs can convert the whole gain to capital gains rates. None of that matters if the stock never clears the strike.
Common mistakes
- Not knowing whether you hold ISOs or NSOs. The grant notice says. The tax treatment is completely different.
- Letting vested options expire after leaving a job because the post-termination window was never checked.
- Assuming the 22% withholding on an NSO exercise covers the tax. At the 32% or 35% bracket it does not.
- Exercising a large ISO block without running the AMT numbers. The exemption absorbs small exercises, not big ones.
- Selling ISO shares a few weeks early and converting a long-term gain into wages.
- Filing with the broker's cost basis. Add the wage income to the strike or you pay tax on the spread twice.
- Comparing options to RSUs one-for-one. An option is worth less than a share; the exchange ratio and the required price rise are the whole question.
Bottom line. A stock option is the right to buy shares at a fixed price; its value is the share price minus the strike, and nothing if the stock does not rise. ISOs and NSOs are economically identical and taxed very differently: NSOs produce wages at exercise, ISOs produce potential AMT at exercise and capital gains at sale if you hold long enough. Learn which type you have, know your expiration and post-termination window, and choose your exercise method for its tax consequences rather than its convenience.
Tax rates, the AMT exemption and the capital gains thresholds are adjusted each year. Verify the current figures in the IRS revenue procedure for the tax year and in Publication 525, and check your own plan document and grant notice for the terms that govern your options.