Prompt CPAIf you work in tech, a meaningful slice of your compensation probably doesn't show up in your regular paycheck. Stock options and restricted stock units can end up being the most valuable part of your total pay — and also the most confusing, and the easiest place to make an expensive tax mistake.
The three forms you'll encounter most often are Incentive Stock Options (ISOs), Non-Qualified Stock Options (NSOs), and Restricted Stock Units (RSUs). They look similar on an offer letter, but they're taxed in very different ways. Understanding those differences — before you exercise, sell, or accept an offer — can be the difference between keeping your gains and handing a surprising amount of them to the IRS.
Here's a plain-English overview.
First, the vocabulary
A few terms come up constantly. Getting these straight makes everything else easier:
- Grant — The date your company awards you equity. For typical RSUs and compensatory stock options, there generally isn't an immediate taxable event.
- Vesting — The schedule on which you actually earn the equity (commonly 25% after one year, then monthly for three more years).
- Exercise (options only) — Paying to convert your options into actual shares, at a fixed "strike" price.
- Strike price — The fixed price you pay per share when you exercise an option, set at grant.
- Spread / bargain element — The difference between the stock's value and your strike price at exercise. This is often where the tax lives.
- FMV — Fair market value, the current worth of a share.
Restricted Stock Units (RSUs)
RSUs are the most common equity at large, public tech companies. They're also the simplest to understand.
How they work: The company promises you actual shares on a vesting schedule. You don't pay anything to receive them.
How they're taxed: RSUs are taxed when they settle — that is, when the shares are actually delivered to you. For most public-company RSUs, settlement happens at vesting, so the two line up. (Some plans, more often at private companies, delay settlement past vesting, which changes the timing.) At settlement, the full value of the shares is treated as ordinary income — just like salary. It shows up on your W-2, and your employer typically withholds taxes, often by selling some of the shares automatically (called "sell to cover").
The catch most people miss: Standard RSU withholding is frequently done at a flat 22% federal supplemental rate. If you're a well-paid engineer whose actual marginal bracket is 32% or 35%, that withholding isn't enough — and you can owe a large balance at tax time even though "taxes were taken out." (Once your cumulative supplemental wages for the year cross $1 million, the excess is withheld at 37% — but even that can miss the mark either way, which is why checking rather than assuming matters.) There's a worked example and a year-end fix further down.
After settlement: Once you own the shares, any further gain or loss is a capital gain or loss, measured from the value at settlement. Hold more than a year before selling for long-term capital gains rates; sell sooner and the resulting gain or loss is generally short-term capital gain or loss, taxed at ordinary income tax rates.
A quick but important distinction: RSUs vs. restricted stock
These sound alike and are constantly confused, but they're different — and the difference determines whether one valuable election is even available to you.
- Restricted stock (RSAs) — You actually own shares now, subject to forfeiture if you leave before they vest. Because you hold real property at grant, you can make an 83(b) election (below). Common at very early-stage startups.
- RSUs — You own nothing at grant, just a contractual promise of future shares. There's no property to make an 83(b) election on, so — per the IRS — an 83(b) election is not available for standard RSUs. This is one of the most common mistakes people make.
Non-Qualified Stock Options (NSOs)
NSOs (sometimes NQSOs) are common at startups and are the more flexible, less tax-advantaged cousin of ISOs.
How they work: You get the right to buy shares at a fixed strike price. You choose whether and when to exercise.
How they're taxed — two events:
- At exercise: The spread (FMV minus strike price) is taxed as ordinary compensation income and reported on your W-2. You owe this tax even if you don't sell the shares.
- At sale: Your basis is what you paid plus the ordinary income recognized at exercise, so any later gain or loss is measured from that adjusted basis — long-term if you held the shares more than a year after exercising.
The catch: Exercising can trigger a real tax bill on "paper" gains. If you exercise deep-in-the-money options in a private company, you may owe ordinary income tax on the spread with no liquid shares to sell to pay it.
One technical note: the "tax at exercise" rule assumes the option had no readily ascertainable fair market value at grant — which is essentially always true for employee grants. In the rare case an option itself is actively traded and does have such a value at grant, the timing shifts to grant. For practical purposes at a startup or public company, plan around exercise.
Incentive Stock Options (ISOs)
ISOs are the most tax-advantaged equity — and the most complicated. They can only be granted to employees and come with special rules.
How they work: Like NSOs, you get the right to buy shares at a fixed strike price.
The potential benefit: If you meet the holding requirements, the gain on sale is generally taxed as long-term capital gain rather than ordinary compensation income — a potentially large savings.
The two holding requirements (together, a "qualifying disposition"):
- Sell the shares more than 2 years after the grant date, and
- More than 1 year after the exercise date.
If both holding-period requirements are satisfied, the sale generally receives qualifying ISO treatment, with the resulting gain generally taxed as long-term capital gain rather than ordinary compensation income. Miss either, and it becomes a "disqualifying disposition," with part of the gain taxed as ordinary income — much like an NSO.
The big catch — the AMT. Here's what trips up even sophisticated tech employees. When you exercise ISOs and hold the shares (rather than selling right away), the spread doesn't count as income for your regular tax — but it does count for the Alternative Minimum Tax (AMT).
This matters more starting in 2026. Recent tax law (the 2025 "One Big Beautiful Bill Act") tightened the AMT beginning in tax year 2026: the income level where the AMT exemption starts phasing out dropped to $500,000 for single filers and $1,000,000 for joint filers, and the phase-out got steeper (losing 50 cents of exemption per dollar, up from 25). The practical effect is that more ISO exercisers get pulled into AMT than in recent years — so if you're weighing an exercise, the current-year math is worth running rather than relying on how it worked a few years ago. Our guide to ISOs and the AMT in 2026 walks through that math in more detail.
The AMT isn't necessarily lost. AMT paid on an ISO exercise often generates a minimum tax credit you can carry forward and use to reduce your regular tax in later years. It's not a permanent double tax — but recovering it can take time and careful year-by-year planning, which is exactly why the timing of the exercise matters so much.
The $100,000 limit. There's also a cap on how much ISO treatment you get: to the extent the value of stock (measured at grant) for which your ISOs first become exercisable in a single calendar year exceeds $100,000, the excess is automatically treated as NSOs, not ISOs. Fast-vesting grants at a higher-value company can quietly blow past this, so it's worth checking rather than assuming every option labeled "ISO" gets ISO tax treatment.
Quick comparison
| RSUs | NSOs | ISOs | |
|---|---|---|---|
| Do you pay to get shares? | No | Yes (exercise) | Yes (exercise) |
| Main taxable event | Settlement (usually at vesting) | Exercise | Exercise (for AMT) and sale (for regular tax) |
| Tax at that event | Ordinary income | Ordinary income on spread | Exercise: generally no regular income tax, but AMT may apply. Sale: capital gain/loss, with ordinary income possible on a disqualifying disposition. |
| Watch out for | Under-withholding | Tax on paper gains | AMT surprise; $100k limit |
| Who can receive | Employees, directors & contractors | Employees & contractors | Employees only |
The RSU withholding gap: why 22% often isn't enough
Your regular paycheck withholding is calibrated to your salary. RSU income is then often withheld at the flat 22% supplemental rate on top of it. But for tax purposes the vest doesn't sit in its own 22% bucket — it stacks on top of your salary, so much of it is often taxed at your highest marginal rate. The difference between what was withheld and what's actually owed doesn't disappear; it shows up as a balance due in April.
A 2026 example. Take a single filer with a $250,000 salary and $150,000 of RSUs settling during 2026, no other income, taking the $16,100 standard deduction, and assume the salary withholding roughly covers the tax on the salary alone:
| Amount | |
|---|---|
| Taxable income without the RSUs | $233,900 |
| Taxable income with the RSUs | $383,900 |
| Federal income tax on the $150,000 RSU layer (roughly $22,300 at 32%, the rest at 35%) | about $51,800 |
| Withheld at the 22% supplemental rate | $33,000 |
| Shortfall | about $18,800 |
That's federal income tax only, using the 2026 brackets for single filers (32% starts above $201,775 of taxable income, 35% above $256,225). Your numbers will differ with filing status, other income, and deductions — and the gap isn't universal. Someone whose income keeps them in the 22% or 24% bracket may be withheld about right, and very large vests that cross the $1 million supplemental-wage line are withheld at 37%, which can over- or under-shoot depending on the rest of the return.
A few related wrinkles are worth knowing:
- Two-earner households. Each employer withholds as if its paycheck is the household's only income, so combined income can land in a higher bracket than either payroll system assumes.
- The 0.9% Additional Medicare Tax. An employer withholds it only on wages it pays above $200,000, regardless of filing status. The tax itself applies above $250,000 of combined wages for joint filers ($200,000 for single filers), so two incomes, or a job change mid-year, can leave it under-withheld — or, for some joint filers, over-withheld and credited back on the return.
- State withholding. States set their own supplemental withholding rules, and the state rate withheld on a vest may not match your actual state rate either.
Fixing it before year-end
If you've had a large vest this year — or have one coming in the fourth quarter — the fix is usually straightforward, and timing matters more than people expect:
- Increase withholding on your remaining paychecks. You can file a new Form W-4 with an extra amount per pay period (Step 4(c)). For underpayment-penalty purposes, federal withholding is generally treated as paid in equal amounts on each quarterly due date, even if it was actually withheld in December — so a late-year withholding increase can often cover a shortfall from earlier in the year.
- Make an estimated payment. The fourth-quarter federal estimate for 2026 is due January 15, 2027. Unlike withholding, an estimated payment generally counts as of the date you make it, so it generally won't fully cure a shortfall from a vest earlier in the year. (See our guide to quarterly estimated taxes for how the payments and due dates work.)
- Check whether you're already inside a safe harbor. You generally avoid the underpayment penalty if your withholding and timely estimates cover at least 90% of this year's tax, or 100% of last year's — 110% if last year's AGI was over $150,000 ($75,000 if married filing separately). Meeting a safe harbor avoids the penalty; you still owe any remaining balance by the April filing deadline.
- If the income came late in the year, say so. The penalty is normally figured as though your income arrived evenly, which can overstate it when a large vest hit in the fourth quarter. The annualized income installment method (Schedule AI of Form 2210) lets you match the required payments to when the income was actually received, which can reduce or eliminate the penalty for earlier quarters.
The underpayment penalty works much like interest — it's figured at the IRS underpayment rate (7% a year for the quarter beginning October 1, 2026) on the amount that was short, for the time it was short. It's rarely catastrophic on its own, but it's avoidable, and the April balance due can be a real cash-flow shock if you sold the shares and spent or reinvested the proceeds.
Common situations where planning pays off
Equity gets genuinely complicated the moment real life intersects with it. A few examples:
- A big vesting or IPO year. A lump of RSUs vesting in one year can push you into a higher bracket and trigger under-withholding. Estimated payments and withholding adjustments can prevent a nasty April surprise.
- Deciding whether (and how much) to exercise ISOs. Modeling the AMT before year-end lets you exercise in tranches and avoid an unnecessary tax bill.
- Leaving a company. Your plan usually gives you a limited window — often 90 days, but check your specific plan — to exercise vested options or forfeit them. There's a tax wrinkle too: an ISO exercised more than three months after you leave (up to one year if you left due to disability) generally loses ISO treatment and is taxed like an NSO. The deadline is both a cash decision and a tax decision.
- Moving to another state. States tax equity differently, and several will tax income you earned while working there even after you've moved away. A cross-country move around a vesting or exercise date can create tax in two states at once — worth planning before, not after.
- QSBS (qualified small business stock). If you hold shares in an eligible C-corporation startup, Section 1202 can exclude much or all of the gain from federal tax when you sell. The 2025 tax law expanded this: for stock acquired after July 4, 2025, there's now a tiered benefit — 50% of the gain excluded at a 3-year hold, 75% at 4 years, and 100% at 5 years — with the per-issuer cap raised to $15 million. (Stock acquired earlier still uses the older 5-year, 100% rule.) The eligibility rules are strict, but for early employees the payoff can be large enough to plan around from day one.
- Concentration risk. When a large share of your net worth sits in one employer's stock, coordinating sales with tax planning matters as much as the tax rules themselves.
Bottom line
Equity compensation is one of the best wealth-building tools in tech — and one of the few areas where a single timing decision, made without understanding the rules, can cost tens of thousands of dollars. The tax code treats ISOs, NSOs, and RSUs very differently, and the right move depends on your specific grant, your income, your company's stage, and your goals.
If you have equity and want to make sure you're not leaving money on the table — or walking into an AMT or withholding surprise — a short conversation before your next vesting date, exercise decision, or job change is worth far more than cleanup afterward.
Frequently asked questions
Should I sell my RSUs as soon as they vest, or hold them?
From a U.S. federal income-tax perspective, there's generally no additional tax benefit to holding vested RSU shares simply because they came from RSUs. You've generally already recognized ordinary income equal to the shares' value when they settle, and your tax basis is generally that same amount — so from there, holding is essentially a decision to keep investing in your employer's stock with after-tax money. Many people sell at settlement and redeploy into a diversified portfolio to avoid over-concentration, then hold only what they'd actively choose to buy. If you do hold, the long-term capital-gains holding period generally begins when you acquire the shares, not when the RSUs were granted.
Is there anything I can do to reduce the tax on a big RSU vest?
You generally can't change that the vest itself is taxed as ordinary income, but you can plan around it: make an estimated tax payment or adjust withholding to cover a shortfall from flat supplemental withholding, and harvest capital losses elsewhere, which can generally offset capital gains. You might also consider donating appreciated shares to charity when they've been held more than a year and otherwise qualify — with one important nuance: a charitable donation generally doesn't reduce the ordinary income from the vest itself, but donating qualifying appreciated shares can provide a charitable deduction while avoiding capital-gains tax on the appreciation. The most valuable move is usually running the numbers before year-end, while there's still time to act.
I'm short on withholding from RSUs that vested earlier this year. Is it too late to fix?
Usually not, if you act before your last paychecks of the year. Federal withholding is generally treated as paid evenly across the year for underpayment-penalty purposes, so increasing your W-4 withholding for the remaining pay periods can often cover a shortfall from a vest months earlier. A fourth-quarter estimated payment (due January 15, 2027 for 2026) also helps, but it generally counts only from the date you pay it. Either way, it's worth estimating the gap first so you're not guessing at the amount.
When I exercise NSOs, how is the tax calculated?
At exercise, the difference between the stock's fair market value and the exercise price is generally taxed as ordinary compensation income and reported on your W-2 — and you owe it even if you don't sell any shares. After that, your basis generally includes what you paid plus the compensation income recognized at exercise, so any later gain or loss is generally measured from that adjusted basis. The trap to watch at a startup: if you exercise, pay ordinary-income tax on that amount, and the shares later fall, you can be left with a capital loss that — if it can't be offset by capital gains — generally reduces ordinary income by only up to $3,000 per year, so exercising illiquid private shares carries real risk worth weighing first.
If I exercise ISOs while my company is still private, will I owe tax even though I can't sell the shares?
Possibly — and this catches people off guard. Exercising an ISO generally doesn't create regular taxable income, but the bargain element can be an AMT adjustment. A large exercise can therefore generate a real AMT liability even though you're holding illiquid private-company shares you can't easily sell to pay it. This is exactly why the size and timing of a private-company exercise deserve modeling before you click "exercise," not after.
My company lets me "early exercise" my options — is that a good idea?
Sometimes. Early exercising (buying shares before they vest), combined with a timely 83(b) election, can start your capital-gains holding period sooner and potentially minimize the compensation income (or, for ISOs, the AMT adjustment) recognized as the shares vest, when the stock is still worth little. But you're putting real cash at risk in a company that may not succeed, and the 83(b) election must generally be filed within 30 days of the transfer, with limited relief for mistakes. It can be powerful for very early employees, but it's a decision to model carefully, not a default.
What happens to my vested and unvested equity if I leave or get laid off?
Unvested equity is generally forfeited when you leave, though your plan documents control and some awards may receive different treatment on termination. For vested stock options, you typically have a limited window — often around 90 days, but check your plan — to exercise or lose them, which can require real cash. For ISOs, an exercise more than three months after employment ends generally doesn't qualify for ISO treatment, subject to certain exceptions (such as disability). RSUs that have already settled are generally just shares you own and keep.
This article is general educational information, not individualized tax advice. Equity compensation rules are nuanced and depend on your specific facts. Please consult a qualified tax professional about your own situation before making decisions.