Stock Options vs. RSU Tax Treatment: ISOs, NSOs, and 83(b)

The tax treatment of stock options versus RSUs comes down to timing and character: RSUs are taxed as ordinary income the moment they vest, non-qualified stock options (NSOs) are taxed as ordinary income when you exercise them, and incentive stock options (ISOs) defer regular income tax until you sell the shares but can trigger the Alternative Minimum Tax at exercise. The equity type you hold decides when the tax bill arrives, what rate applies, and which planning moves are open to you. Getting any of these wrong can cost thousands in avoidable tax.

RSUs: Taxed at Vesting

An RSU is a promise from your employer to deliver shares after you meet a vesting condition, usually continued employment for a set period. You own nothing until vesting, so the grant itself creates no tax event. When the shares land in your account on the vesting date, the IRS treats the full fair market value as ordinary compensation income.¹ Your employer reports it in Box 1 of your W-2, right alongside your salary.²

Because RSU income is supplemental wages, your employer withholds federal income tax at a flat 22% on the first $1 million of supplemental wages for the calendar year. Anything above $1 million is withheld at 37%.³ Social Security withholding of 6.2% applies up to the 2026 wage base of $184,500, and Medicare withholding is 1.45%.⁴ Most companies handle the tax through a net settlement: they hold back a portion of the vesting shares and deposit the rest in your brokerage account.

Here is where employees run into trouble. The 22% flat withholding is often lower than the actual marginal rate for someone receiving meaningful equity compensation. If your combined salary and RSU income lands you in the 32% or 35% bracket, that 22% withholding will not cover the full liability. You will owe the difference when you file. Planning for that gap early in the year prevents an ugly surprise in April.

NSOs: Taxed at Exercise

An NSO gives you the right to buy company shares at a locked-in strike price. The grant is not a taxable event as long as the option lacks a readily ascertainable fair market value, which is almost always the case for employer-granted options.¹ The tax hit arrives when you exercise.

At exercise, the IRS taxes the spread: the difference between your strike price and the stock’s fair market value that day. If your strike is $10 and the stock trades at $40, the $30 spread is ordinary income. Your employer reports it on your W-2 and withholds federal income tax, Social Security, and Medicare the same way it would for a bonus.³ This happens whether or not you sell the shares. Exercise and hold, and you still owe tax on the full spread immediately.

That creates a real cash-flow problem. You have bought shares and owe tax on paper income, but you may not have the liquidity to cover both. Most brokerages offer a cashless exercise (a same-day sale) that exercises and sells enough shares to cover the strike price and withholding in one motion. The convenience costs future appreciation on the sold shares, and the whole gain stays at ordinary income rates.

When Options Are Underwater

If the stock’s market price drops below your strike, the options are underwater and have no economic value to exercise. Letting them expire triggers no tax event and creates no deductible loss. The spread cannot go negative for tax purposes.

ISOs: Regular Tax Deferred, AMT Live

ISOs carry the most favorable regular-income-tax treatment of the three, and the most complexity. When you exercise an ISO, no regular federal income tax is due on the spread, and your employer withholds nothing for income tax, Social Security, or Medicare.⁵ That is a substantial difference from NSOs and RSUs.

The catch is the Alternative Minimum Tax. Under IRC Section 56(b)(3), the favorable Section 421 treatment does not apply when calculating alternative minimum taxable income.⁶ You add the exercise spread back to your income on IRS Form 6251 to determine whether you owe AMT.⁷ For 2026, the AMT exemption is $90,100 for single filers and $140,200 for married couples filing jointly, phasing out at $500,000 and $1,000,000. A large ISO exercise can push you past those thresholds and generate a bill even though you have not sold a share.

Qualifying vs. Disqualifying Dispositions

What happens when you eventually sell decides whether the ISO advantage survives. A qualifying disposition means selling at least two years after the grant date and at least one year after the exercise date.⁸ Clear both holding periods and the entire gain from strike to sale price is taxed at long-term capital gains rates.

Sell before satisfying either holding period and you have a disqualifying disposition. The spread at exercise (fair market value on exercise date minus strike price) is reclassified as ordinary income. Any additional gain above the exercise-date fair market value is capital gain. One detail worth flagging: even in a disqualifying disposition, your employer is not required to withhold income tax on the ordinary income portion.⁵ You pay it yourself through estimates or at filing.

Recovering AMT Through the Minimum Tax Credit

If you paid AMT because of an ISO exercise and later sell the shares in a qualifying disposition, you may have a minimum tax credit that offsets future regular tax. You calculate it on IRS Form 8801, carrying forward AMT from prior years and applying it in years when your regular tax exceeds your tentative minimum tax.⁹ The credit can take several years to fully recover, but in many cases it makes AMT a timing difference rather than a permanent extra tax.

The Section 83(b) Election

If your company lets you early-exercise options before vesting, or if you receive actual restricted stock (not RSUs) subject to vesting, a Section 83(b) election can change the outcome dramatically. Filing it, you choose to recognize income based on the stock’s value at transfer rather than waiting until vesting.¹

This matters most for early-stage startup employees. Early-exercise options when the stock is worth $0.10 per share and your ordinary income is $0.10 minus the strike price, often near zero. Future appreciation then qualifies for long-term capital gains treatment once you hold the shares for a year. Skip the election and you owe ordinary income tax on the full fair market value at each vesting, which could be far higher if the company has grown.

The deadline is absolute. You must file within 30 days of the property transfer. No extensions, and the election is irrevocable.¹⁰ You file IRS Form 15620 by mail to the IRS office where you file your income tax return and provide a copy to your employer. Missing the 30-day window is among the most common and costly mistakes in equity compensation. The risk on the other side: if you leave and forfeit unvested shares, you have paid tax on income you will never receive, with no deduction available for the forfeiture.

Capital Gains Holding Periods After the First Tax Event

Once you have cleared the initial tax event on RSUs or NSOs, any further gain or loss on the shares is a capital gain or loss. Long-term rates of 0%, 15%, or 20% apply to shares held more than a year.¹¹ Short-term gains are taxed at your ordinary rate.

The one-year clock starts differently depending on the equity type:

RSUs: the holding period begins the day after the vesting date, with cost basis equal to the fair market value on that date.
NSOs: the holding period begins the day after the exercise date, with cost basis equal to the fair market value at exercise.
ISOs in a qualifying disposition: you must hold at least one year after exercise and two years after grant. Your cost basis is the original strike price, and the full gain qualifies for long-term capital gains treatment.

For 2026, long-term capital gains rates are 0% for single filers with taxable income up to $49,450 ($98,900 married filing jointly), 15% up to $545,500 ($613,700 married filing jointly), and 20% above those amounts. Keep detailed records of grant dates, vesting dates, exercise dates, and fair market values at each event. Brokerages sometimes report incorrect cost basis on equity compensation shares, so verify 1099-B figures against your own records before filing.

Surtaxes That Ride Along

Two federal surtaxes hit equity compensation on top of regular income and capital gains tax. Both use fixed thresholds that do not adjust for inflation, so more people trigger them every year.

Additional Medicare Tax (0.9%)

An extra 0.9% Medicare tax applies to wages above $200,000 for single filers, $250,000 for married filing jointly, and $125,000 for married filing separately. Your employer must start withholding it once your wages exceed $200,000 in a calendar year, regardless of filing status.⁴ Because RSU vesting income and NSO exercise spreads count as wages, a large vesting event or exercise can push you across. You reconcile the tax on Form 8959.

Net Investment Income Tax (3.8%)

A 3.8% tax applies to net investment income when your modified adjusted gross income exceeds $200,000 (single), $250,000 (married filing jointly), or $125,000 (married filing separately).¹² Capital gains from selling equity compensation shares count as net investment income. The tax hits the lesser of your net investment income or the amount by which MAGI exceeds the threshold. A single filer with $300,000 in MAGI and $50,000 in capital gains from RSU shares pays 3.8% on $50,000 (the smaller of $50,000 in investment income or $100,000 over the threshold).

Between the 20% top capital gains rate, the 3.8% NIIT, and state income taxes, the effective rate on a large stock sale can climb well above 30% even on long-term gains. Model this before selling a concentrated position in a single tax year rather than spreading sales.

The Wash Sale Trap for RSU Holders

The wash sale rule disallows a capital loss if you buy or acquire substantially identical securities within 30 days before or after the sale. What catches RSU holders off guard is that a vesting event counts as an acquisition. Sell company shares at a loss and have more RSUs vest within that 61-day window, and the IRS disallows the loss.¹³

The disallowed loss is not gone forever. It gets added to the cost basis of the newly acquired shares, deferring the tax benefit rather than eliminating it. But if your RSUs vest on a regular quarterly schedule, the 61-day window can overlap with nearly every vesting date, making it practically impossible to harvest losses on company stock through normal sales. Even sell-to-cover transactions on the vesting date itself can raise wash sale issues. Track all vests, purchases, and sales of company stock carefully, and report basis adjustments on Form 8949.

Tax Forms to Keep Straight

Equity compensation generates more paperwork than most employees expect. Staying on top of these forms prevents misreported income and incorrect basis:

Form W-2 shows RSU vesting income and NSO exercise spreads in Box 1 as ordinary wages. This is your primary record of ordinary income recognized.
Form 1099-B reports sale proceeds from your brokerage. Check the cost basis carefully, because brokerages frequently report RSU and option shares with incorrect or missing basis.
Form 3921 is filed by your employer when you exercise ISOs. It shows the grant date, exercise date, strike price, fair market value at exercise, and share count, all of which you need for your AMT adjustment and for determining whether a future sale is qualifying.
Form 6251 is where you calculate whether you owe AMT. The ISO exercise spread goes here even though no regular income tax is due.⁷
Form 8949 and Schedule D report capital gains and losses from share sales. Wash sale adjustments and basis corrections go here.
Form 15620 is the Section 83(b) election, due within 30 days of receiving restricted property or early-exercising options.¹⁰

Keep copies of every form your employer and brokerage provide, along with your own records of grant dates, vesting dates, exercise dates, and fair market values. The IRS matching process for equity compensation is more aggressive than many employees realize, and discrepancies between your return and the forms your employer filed will generate automated notices.

1
Office of the Law Revision Counsel. 26 USC 83 – Property Transferred in Connection With Performance of Services
2
Internal Revenue Service. IRS Letter 2024-0010
3
Internal Revenue Service. Publication 15 (Circular E) – Employer’s Tax Guide
4
Internal Revenue Service. Topic No. 751, Social Security and Medicare Withholding Rates
5
Office of the Law Revision Counsel. 26 USC 421 – General Rules
6
Office of the Law Revision Counsel. 26 USC 56 – Adjustments in Computing Alternative Minimum Taxable Income
7
Internal Revenue Service. Instructions for Form 6251
8
Office of the Law Revision Counsel. 26 USC 422 – Incentive Stock Options
9
Internal Revenue Service. About Form 8801, Credit for Prior Year Minimum Tax – Individuals, Estates, and Trusts
10
Internal Revenue Service. Form 15620, Section 83(b) Election
11
Internal Revenue Service. Topic No. 409, Capital Gains and Losses
12
Office of the Law Revision Counsel. 26 USC 1411 – Imposition of Tax
13
Internal Revenue Service. Publication 550, Investment Income and Expenses