Most clients I talk to know they have stock options and roughly what they're worth. But ask them if they have Incentive Stock Options (ISOs) or Non-Qualified Stock Options (NSOs), and you'll usually get a blank look. Ask about Alternative Minimum Tax, and it's the same thing.
The difference matters because the tax treatment is completely different. Making the wrong decision could cost you tens of thousands of dollars.
The Two Types of Stock Options
There are two types of stock options: Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs). You need to know which one you have because the tax implications are completely different.
Incentive Stock Options (ISOs)
ISOs can only be granted to employees, not to contractors, advisors, or board members. The main benefit of an ISO is that you don't pay ordinary income tax when you exercise them.
You get to buy the shares at the strike price, and there's no immediate tax hit on the difference between what you paid and what the shares are worth.
But there's a catch: ISOs are subject to Alternative Minimum Tax, which I'll explain below.
To get the favorable tax treatment on ISOs, you have to hold the shares for at least one year after you exercise and at least two years after the grant date. If you meet both requirements, you only pay long-term capital gains rates when you eventually sell, instead of ordinary income.
That's a meaningful difference. We're talking about a top federal rate of 20% for capital gains versus 37% for ordinary income. Sometimes that capital gains rate can be as low as 15% if your income is low enough.
A few other things about ISOs:
- There's a $100,000 limit on the value of ISOs that can vest in any given year
- They expire 10 years after they're granted
- If you leave your company, you only have 90 days to exercise them and keep the ISO tax treatment
Non-Qualified Stock Options (NSOs)
NSOs are more flexible. They can be granted to anyone: employees, contractors, advisors, board members. The tax treatment is straightforward but less favorable.
When you exercise NSOs, you pay ordinary income on the spread. The spread is the difference between what you paid (your strike price, maybe $5) and the fair market value of the shares on the day you exercise (hopefully $10, $20, or $30).
That spread is treated as compensation. It shows up on your W2, and you pay income taxes on it. You also pay payroll taxes on it, which means Social Security and Medicare taxes.
There's no special holding period for NSOs. The tax hit happens at exercise, period. For most people, we exercise and sell the shares immediately, as opposed to holding like you might do with an ISO.
Here's the simple version: With ISOs, you don't pay tax at exercise (except potentially AMT), and if you hold long enough, you pay capital gains when you sell. With NSOs, you pay ordinary income tax at exercise and then pay capital gains on any appreciation that happens after.
ISOs sound better, and in many cases they are. But the AMT piece complicates things.
Understanding Alternative Minimum Tax (AMT)
Alternative Minimum Tax is a parallel tax system. It was created in 1969 to make sure high income taxpayers couldn't just use deductions and exclusions to avoid paying taxes entirely.
Here's how it works: You calculate your taxes twice, once under the regular system and once under the AMT system. Then you pay whichever number is higher.
The AMT system adds back certain items that you can exclude or deduct under the regular system. One of those items is the spread on your ISO exercises.
When you exercise ISOs and hold the shares, you don't owe any regular income tax on that spread. But you do have to add that spread to your income when calculating AMT. If your AMT calculation comes out higher than your regular tax, you have to pay the AMT.
This can be a surprise for people because they exercised a bunch of ISOs, they didn't sell any shares (so they got no cash out of the deal), and then they get a tax bill anyway. You have to have cash on the side to pay that tax liability.
The 2026 AMT Rule Changes
For tax year 2026 (which you'll file in early 2027), the AMT exemption is $90,100 for single filers and $140,200 for married filing jointly. The exemption is the amount you can earn before AMT starts to apply.
The exemption phases out once your income hits a certain level. For 2026, the phase-out starts at $500,000 for single filers and $1 million for married filing jointly. The phase-out rate is 50 cents for every dollar over the threshold.
This is a significant change from 2025. The One Big Beautiful Bill Act, which passed in July 2025, lowered those phase-out thresholds and doubled the phase-out rate. In 2025, the thresholds were $626,350 and $1,252,700.
More high income taxpayers are going to be affected by AMT starting in 2026. If you're a high earner with large ISO exercises, you need to model this out carefully before you do anything.
The AMT Credit
There is some good news. When you pay AMT because of ISO exercises, you generate what's called an AMT credit. That credit carries forward indefinitely.
In future years, when your regular tax exceeds the AMT, you can use those credits to reduce what you owe. The AMT issue on ISOs is more of a timing issue than a permanent extra tax. You're essentially prepaying taxes that you would've owed later, but it still creates a cash flow problem in the year you exercise, and you need to be ready for that.
When to Exercise Your Options
There's no single right answer on when to exercise your options. It depends on your situation. But here are the factors I think about with clients.
The Spread
The spread is the difference between your strike price and the current fair market value. A larger spread means a bigger tax impact, whether it's AMT for ISOs or ordinary income for NSOs.
If the spread is small, you trigger minimal tax and you can start your holding period clock for long-term capital gains treatment. If the spread is large, you need to think carefully about the tax bill you're creating.
Your Income This Year vs. Other Years
Tax rates are progressive. If you're having a lower income year for whatever reason, that might be a good time to exercise your NSOs. You'll pay a lower marginal rate on them.
For ISOs, a lower income year means you're less likely to trigger AMT, and you'll trigger less of it.
On the flip side, if you're having a high income year (maybe because you got a bonus or some restricted stock units), adding an ISO exercise on top of that could push you far into AMT territory.
Early in the Calendar Year
I generally recommend exercising early in the year if you have ISOs. Here's why:
If you exercise your ISOs in January and hold the shares, you've got the rest of the year to see what happens. If the stock drops significantly, you can sell before year end and avoid the AMT adjustment entirely. That's called a disqualifying disposition. You lose the favorable capital gains treatment, but you also eliminate your AMT problem.
If you exercise in December and hold through year end, you're locked in. The AMT adjustment happens regardless of what the stock does after that.
Exercise in Chunks
If you have a large option grant, you don't have to exercise it all at once. You can exercise in chunks over multiple years, which spreads out the tax impact.
This is particularly useful for ISOs. You might exercise enough each year to stay below the AMT threshold, or at least minimize how much AMT you're triggering.
Specific Strategies for ISOs and NSOs
For ISOs: Meet the Holding Period
If you can afford to hold, the math usually favors it. You need to hold for at least one year after you exercise and two years after the grant date. Then you get the long-term capital gains rate on the entire gain from your strike price.
Yes, you might pay some AMT along the way, but remember that generates credits you can use later. Capital gains rates are meaningfully lower than ordinary income.
For ISOs: Calculate Before You Exercise
Don't exercise your ISOs without running the numbers first or having us help you. You need to know what your AMT exposure is going to be. You need to know if you have the cash to pay that bill. You need to understand what happens if the stock drops after you exercise.
We build projections like this for clients before they exercise anything. This isn't something you want to figure out after the fact.
For NSOs: Exercise in Low Income Years
NSOs are taxed at ordinary income. If you have flexibility on timing, exercise in years when your income is lower. You'll pay a lower marginal rate.
For NSOs: Spread It Out
If you have a large NSO grant, don't exercise it all in one year and spike yourself into the highest tax bracket. Spread it over multiple years.
Charitable Giving
If you're charitably inclined, donating appreciated shares can be powerful. You get a deduction for the fair market value of the shares, and you avoid paying capital gains on that appreciation.
This works well for shares you've exercised and held, but it doesn't work for unexercised options. If you're exercising and sitting on a bunch of gains, you can contribute those shares to a donor-advised fund or another charity. It can be way more tax efficient than selling and then donating the cash.
Leaving the Company
This is where people get into trouble. You leave the company (maybe it's voluntary, maybe it's not), and suddenly you only have 90 days to make a decision about your stock options.
For ISOs, that 90-day window is firm. If you don't exercise within 90 days of your last day of employment, your ISOs either expire or convert to NSOs, depending on your company's plan. Either way, you lose the ISO tax treatment.
For NSOs, some companies offer longer exercise windows, but 90 days is still pretty common.
You're in this tough situation where you have limited time to figure out if you want to write a large check to buy shares in a company you don't even work for anymore.
How to Think About It
Here are the questions I ask:
What's the total cost to exercise? That's the number of shares times your strike price.
What will the tax bill be? For ISOs, estimate your AMT exposure. For NSOs, estimate the ordinary income tax on the spread.
Do you have the cash? Can you afford the exercise cost plus the tax bill without creating financial stress?
What do you believe about your company's future? Is there a realistic path to a liquidity event like an IPO or acquisition? What's your honest assessment of the company's prospects?
How long until that liquidity event? If the company is years away from an exit, you're tying up capital in an illiquid investment for a long time.
What percentage of your net worth does this represent? If exercising would put 30%, 40%, or 50% of your net worth into a single private company stock, that's a lot of concentration risk.
Can you afford to lose the entire investment? Both public and private company stocks can go to zero. Even if they don't go to zero, it's easy for your stock options to go underwater and become worthless. If losing this money would meaningfully impact your financial security, that's the most important information you need to know.
There's no universal right answer. What's not reasonable is making a rush decision in the final week of your 90-day window because you didn't think about it until then. If you're leaving a company with stock options, start thinking about this immediately.
Key Takeaways
Here's what we've covered:
Know what type of options you have. ISOs and NSOs have fundamentally different tax treatments. You can't make good decisions without knowing which one you have.
Understand AMT before you exercise ISOs. The spread on ISO exercises is an AMT preference item. If you exercise and hold, you could owe taxes even though you don't have cash. The 2026 rules make this even more likely for high income taxpayers than in prior years.
Be thoughtful about timing. Exercising early in the year gives you flexibility. Spreading exercises across years reduces the tax spike. Lower income years are better for NSOs.
If you're leaving a company, don't wait until the last minute. You have 90 days. Use that time to actually think through the decision, not panic.
Work with a professional who understands stock options. Exercise timing and taxation is complicated. The interplay between your regular tax, AMT, state taxes, and your overall financial plan is not something you should guess at.
That's what we do at Quarry Hill Advisors. If you have questions about your specific situation, reach out and schedule a time with me or one of our other planners.
Ready to find out if we're the right fit for your financial planning needs? Schedule a complimentary discovery meeting where we'll provide a real assessment of how we can help your specific financial situation.
-A note from Bjorn Amundson, CFP®
This material is intended for educational purposes only. You should always consult a financial, tax, or legal professional familiar with your unique circumstances before making any financial decisions. Nothing contained in the material constitutes a recommendation for purchase or sale of any security, investment advisory services or tax advice. The information and opinions expressed in the linked articles are from third parties, and while they are deemed reliable, we cannot guarantee their accuracy.
