RSUs, ISOs, and NSOs: A Tax Playbook for Tech Employees
The three instruments are taxed in three different ways. The timing decisions around each one are where most of the money is won or lost.
TL;DR
RSUs are ordinary income at vest — withholding is usually insufficient. ISOs get favorable long-term treatment if you clear the holding periods, but the AMT trap is real. NSOs are always ordinary at exercise, with any further gain treated as capital. The single most common mistake is failing to estimate quarterly taxes in a vest year and landing a five-figure balance-due surprise.
RSUs: ordinary income at vest
A restricted stock unit becomes ordinary compensation the moment it vests — not when you sell. Your employer reports the fair market value on the vest date as wages on your W-2 and withholds federal tax, typically at the 22% supplemental rate. For anyone whose marginal rate exceeds 22% (most people who receive meaningful RSUs), this withholding is not enough.
The practical playbook: make a Q4 estimated tax payment equal to the gap between your marginal rate and 22% on the dollar value of your RSU vesting during the year. Skip this, and April will deliver a balance-due surprise plus underpayment penalties.
ISOs and the AMT trap
Incentive stock options are the most tax-advantaged instrument on this list — and the easiest to mishandle. Exercising an ISO and holding the shares is not a regular-tax event, but the bargain element (FMV at exercise minus strike price) is an AMT preference item. For employees exercising deep in-the-money ISOs, this can generate a five-figure AMT bill in the year of exercise on stock you haven't sold.
The qualifying disposition rules: to capture long-term capital gain treatment on the full spread, you must hold the shares at least two years from grant and one year from exercise. A disqualifying disposition converts the bargain element back to ordinary income on a Form W-2 adjustment.
Planning approach we use: model AMT before year-end, exercise in tranches that stay under the AMT crossover, and consider early exercise + 83(b) when the spread is small. This is the most common place we add meaningful value for tech-employee clients.
NSOs: straightforward but often mistimed
Non-qualified stock options are ordinary at exercise. The spread between FMV and strike is wages, taxed at your marginal rate, reported on Form W-2, and subject to payroll tax. Any appreciation after exercise is capital gain with its own holding period.
Two common mistakes: exercising and holding without setting aside cash to cover the ordinary tax (a liquidity problem) and exercising in a year your marginal rate is unusually high when the next year's rate will be lower (an avoidable timing loss).
ESPP lookbacks
Qualified ESPPs with a lookback feature can be among the most reliable return-on-time in compensation. The 15% discount off the lower of offering-date and purchase-date price, compounded over a holding period, commonly produces 30%+ annual returns with modest risk.
The tax mechanics: the discount portion is ordinary income at sale, any additional gain is capital. Qualifying dispositions (two years from offering, one from purchase) convert most of the benefit to long-term treatment.
83(b) elections
An 83(b) election lets you recognize ordinary income on restricted stock at grant rather than vest. For early-stage company equity where the grant-date value is near zero, this is often free — and starts the long-term capital gains clock immediately. The election must be filed with the IRS within 30 days of grant. Miss the window and there is no extension.
When this matters most: early-stage startup equity, restricted stock in exchange for services, and early exercise of stock options in an RSA plan.
State sourcing for movers
Equity comp granted in one state and vested in another creates a sourcing question that most preparers quietly hand-wave. Many states (California, New York) use a "workdays" method that allocates income to the state based on days worked from grant through vest. Done correctly, a move from a high-tax state to a no-tax state late in the vesting cycle can significantly reduce the state tax bill on a large RSU tranche.
If you have a meaningful vest year coming up, a multi-year ISO exercise decision, or equity granted across state lines, an hour of modeling before year-end generally pays for itself many times over.