ISO vs NSO: how the tax difference changes your payout

Both are stock options with a strike price. The difference is when the IRS takes its cut, and how big that cut is.

The short version

With NSOs (non-qualified stock options), the moment you exercise, the gap between the current 409A price and your strike (the “bargain element”) is taxed as ordinary income, just like salary. Any growth after that is taxed as a capital gain when you sell.

With ISOs (incentive stock options), there's no regular income tax at exercise. If you hold the shares at least two years from grant and one year from exercise, the entire gain above your strike is taxed at long-term capital gains rates, which are typically much lower than income rates. The catch is the alternative minimum tax (AMT): the bargain element counts toward AMT in the year you exercise, so exercising ISOs can create a tax bill even though you haven't sold anything.

When the difference is big

• The 409A has risen well above your strike. A large bargain element means a large income-tax bill for NSOs, or a large AMT exposure for ISOs.
• You exercise early and hold. This is where ISOs shine: the gain from exercise to exit can qualify for long-term rates.
• You exercise and sell on the same day at exit. Here ISOs and NSOs are taxed almost identically, as ordinary income on the spread, because the ISO holding period isn't met.

Things that trip people up

Only employees can hold ISOs; advisors and contractors get NSOs. ISOs that first become exercisable in a single year above $100K of value (measured at grant) are treated as NSOs for the excess. And leaving your company usually gives you 90 days to exercise ISOs before they convert to NSOs or expire, so check your plan.

Use the calculator below to model your grant as an ISO, then switch the type to NSO (or add a second offer) to see the difference in each exit scenario, side by side. Have RSUs instead? Start with the ISO vs NSO vs RSU primer.

Educational purposes only. Not financial, tax, or legal advice.