Non-qualified stock options are taxed in two stages. When you exercise, the difference between the stock’s fair market value and your exercise price is treated as ordinary wages, taxed at rates as high as 37 percent and subject to payroll taxes.1Internal Revenue Service. Topic No. 427, Stock Options When you later sell the shares, any additional gain or loss is a capital gain or loss, measured from the fair market value on the exercise date. Nothing is taxed at grant, and nothing is taxed as the options vest.
Grant and Vesting Are Not Taxable
Receiving an NSO grant does not create income. The option’s fair market value is not readily determinable at that point, so the IRS does not treat the grant itself as compensation.1Internal Revenue Service. Topic No. 427, Stock Options Vesting is not taxable either. The IRS treats the vesting period as a continuing service condition rather than a completed transfer of property, so income is recognized only when you actually exercise.2Office of the Law Revision Counsel. 26 USC 83 – Property Transferred in Connection With Performance of Services
Ordinary Income at Exercise
Exercise is the main tax event. When you pay the exercise price and acquire the shares, the spread between the stock’s current fair market value and what you paid is ordinary income.1Internal Revenue Service. Topic No. 427, Stock Options Exercise 1,000 shares at $10 when the stock trades at $50, and $40,000 is taxable wages for that year. It does not matter whether you sell the shares immediately or keep them; the tax is triggered by the exercise itself.
That income is taxed at your regular federal rates, which run up to 37 percent depending on your total taxable income.3Internal Revenue Service. Federal Income Tax Rates and Brackets If you exercise and hold, you owe the tax on a paper gain and need cash on hand to pay it.
Exercise also resets your cost basis in the shares. In the example above, your basis becomes $50 per share, not the $10 you paid. That basis is what you compare against the sale price later.
Payroll Taxes on the Spread
The spread is treated as wages, so FICA applies:
- Social Security tax of 6.2 percent, up to the annual wage base. For 2026, the base is $184,500; if your other wages have already crossed it, no further Social Security tax is owed on the spread.4Internal Revenue Service. Topic No. 751, Social Security and Medicare Withholding Rates5Social Security Administration. 2026 Cost-of-Living Adjustment (COLA) Fact Sheet
- Medicare tax of 1.45 percent on the full spread, with no wage cap.4Internal Revenue Service. Topic No. 751, Social Security and Medicare Withholding Rates
- Additional Medicare Tax of 0.9 percent on wages above $200,000 (single) or $250,000 (married filing jointly). Employers must start withholding it once your wages cross $200,000, regardless of filing status.6Internal Revenue Service. Topic No. 560, Additional Medicare Tax
Combined, these payroll taxes add roughly 2.35 to 9.05 percent on top of income tax on the spread, depending on how much Social Security you have already paid through regular wages.
Withholding Rarely Covers the Full Bill
Employers treat the spread as supplemental wages. Federal income tax is withheld at a flat 22 percent on the first $1 million of supplemental wages in a calendar year, and 37 percent on anything above that.7Internal Revenue Service. Publication 15 (2026), (Circular E), Employer’s Tax Guide Your FICA share is deducted from the transaction or paid separately. The income appears on your W-2 for the year of exercise.
The catch: 22 percent withholding is often lower than your actual marginal rate. If you land in the 32 or 35 percent bracket after the spread is added to your other income, you will owe a large balance at filing time, and possibly an underpayment penalty. You can close the gap by asking your employer to withhold additional amounts via Form W-4, or by making a quarterly estimated payment to the IRS with Form 1040-ES for the quarter in which you exercised.8Internal Revenue Service. Estimated Tax
Capital Gains Tax When You Sell
Once you own the shares, further changes in value fall under the capital gains rules. Your holding period starts on the exercise date.9Office of the Law Revision Counsel. 26 USC 1222 – Other Terms Relating to Capital Gains and Losses
- Sell within one year of exercise and any gain above your cost basis is short-term, taxed at ordinary income rates.
- Hold for more than one year after exercise and the gain qualifies for long-term rates of 0, 15, or 20 percent depending on your total taxable income.10Internal Revenue Service. Topic No. 409, Capital Gains and Losses
For 2026, the 20 percent long-term rate begins at taxable income above $545,500 for single filers and $613,700 for married couples filing jointly.
Higher earners may also owe the 3.8 percent net investment income tax on the gain. NIIT applies to the lesser of your net investment income or the amount by which your modified adjusted gross income exceeds $200,000 (single or head of household), $250,000 (married filing jointly), or $125,000 (married filing separately). Stacked on top of the 20 percent long-term rate, NIIT brings the top federal rate on the eventual gain to 23.8 percent.11Internal Revenue Service. Topic No. 559, Net Investment Income Tax
Check Your Cost Basis on Form 1099-B
When you sell, your brokerage reports the sale on Form 1099-B.12Internal Revenue Service. Instructions for Form 1099-B (2026) Many brokerages report the cost basis as the exercise price you paid rather than the fair market value at exercise. Because you already paid ordinary income tax on the spread, using the lower figure would tax the same dollars twice.13Internal Revenue Service. Stocks (Options, Splits, Traders)
Compare the basis on your 1099-B to the fair market value your employer used on your W-2 at exercise. If they differ, report the correction on Form 8949 when you file. This is easy to miss and can cost thousands.
What Happens If the Stock Drops After Exercise
Selling for less than your cost basis creates a capital loss. Capital losses offset capital gains dollar for dollar, but if losses exceed gains, only $3,000 per year ($1,500 if married filing separately) can be deducted against ordinary income. Anything left over carries forward.10Internal Revenue Service. Topic No. 409, Capital Gains and Losses
The asymmetry can be brutal. Say you recognize $100,000 of ordinary income at exercise when the stock is $50, then it falls to $10 before you sell. You owe full ordinary income tax on the $100,000 spread, but the $40,000 capital loss trickles onto your return at $3,000 per year against ordinary income unless you have gains to absorb it. Timing exercises and sales to avoid this outcome is one of the most important pieces of NSO planning.
Timing Levers Worth Knowing
Section 83(b) Election for Early Exercise
Some plans let you exercise before your options vest. If you do, filing a Section 83(b) election lets you be taxed on the spread at the time of exercise instead of as the shares vest.2Office of the Law Revision Counsel. 26 USC 83 – Property Transferred in Connection With Performance of Services If the stock is worth very little at that point, the spread is small or zero, and future appreciation can qualify for long-term capital gains if you hold more than a year past the transfer.
The deadline is unforgiving: the election must be filed no later than 30 days after the shares are transferred to you, extended to the next business day only if that day is a weekend or holiday. Miss it and the election is gone.14Internal Revenue Service. Form 15620 (Rev. 4-2025) Section 83(b) Election The election is also irrevocable. If you leave before the shares vest and forfeit them, you cannot recover the tax you already paid.
Section 83(i) Deferral at Private Companies
Employees at qualifying private companies can elect under Section 83(i) to defer income tax on exercised options for up to five years, easing the cash squeeze that comes from owing tax on shares you cannot sell.15Office of the Law Revision Counsel. 26 US Code 83 – Property Transferred in Connection With Performance of Services The company must have a written plan granting equity to at least 80 percent of its U.S. employees during the year, and certain executives and one-percent owners are excluded. The election is due within 30 days of the shares vesting or becoming transferable, whichever comes first.16Internal Revenue Service. Guidance on the Application of Section 83(i), Notice 2018-97 One important warning: the tax at the end of the deferral is based on the stock’s value when your rights first vested, so if the price drops in the meantime you still owe tax on the higher original amount.
The Post-Termination Exercise Window
When you leave the company, vested NSOs typically expire on a short clock. Many plans set the window at 90 days after termination; some run 30 days, others several years. Anything unexercised at the deadline is forfeited. Exercising after you leave carries the same tax hit as exercising while employed, so if the company is still private, you need cash for both the exercise price and the resulting tax. Read your option agreement before any job change.
State Income Tax
Most states with an income tax treat the NSO spread as supplemental wages and withhold accordingly, at rates that vary widely. A few states have no income tax at all. If you lived or worked in more than one state during the period you earned the options, more than one state may claim a share of the income under its own allocation rules. Check your state’s treatment before you exercise.