RSUs are taxed as ordinary income the day they vest, based on the share value that day. Non-qualified stock options (NSOs) are taxed as ordinary income when you exercise, on the spread between the strike price and the market price. Incentive stock options (ISOs) owe no regular income tax at exercise, but the spread counts for alternative minimum tax, and selling too early converts the tax break into ordinary income.

Equity compensation looks like free money until the tax bill arrives. The pattern we see most: someone vests a large RSU tranche or exercises options, the employer withholds at a flat rate that does not match their real marginal rate, and April brings a five-figure surprise. This guide covers how each type of equity is taxed, where the traps are, and what to plan before a liquidity event. Everything here is federal tax; your state adds its own layer on top.

How are RSUs taxed?

Restricted stock units are the simplest form of equity comp to understand and the easiest to get wrong on your return. An RSU is a promise: your employer will deliver shares (or cash) once you meet the vesting conditions, usually staying employed through a vesting date.

You owe ordinary income tax on the fair market value of the shares on the day they vest, minus anything you paid for them (usually zero). That amount lands on your W-2 as wages. There is no tax when RSUs are granted, because nothing has been transferred yet. The taxable event is vesting, full stop. This follows the rule that property transferred for services is taxed when your rights are no longer subject to a substantial risk of forfeiture (IRC Section 83, IRS Publication 525).

Two things trip people up:

The withholding rarely matches your actual tax. Employers withhold on RSU income as supplemental wages: a flat 22% on supplemental wages up to $1 million for the year, and a mandatory 37% on amounts above $1 million. If your marginal rate is 37% and your employer withheld 22%, you owe the difference at filing time. If your RSU vest pushes total supplemental wages past $1 million, the 37% rate kicks in on the excess (IRS Publication 15, Treas. Reg. 31.3402(g)-1).

Your cost basis is the vest-day value. After vesting, the shares are yours with a tax basis equal to the amount you already paid income tax on. When you sell later, only the change in value after vesting is a capital gain or loss. If you hold more than a year from the vesting date, that later gain or loss is long-term. Check your 1099-B: brokers sometimes report the wrong basis for RSU sales, and you correct it on Form 8949 rather than paying tax twice (IRS Instructions for Form 8949).

How are non-qualified stock options (NSOs) taxed?

NSOs, also called nonstatutory options, give you the right to buy shares at a fixed strike price. Most options that are not ISOs or ESPP options fall in this bucket.

There is no tax when an NSO is granted (for the typical option with no readily determinable market value). When you exercise, you owe ordinary income tax on the spread: the fair market value of the stock on exercise day minus what you paid. That spread is wages, reported on your W-2, and your employer withholds on it. When you later sell the shares, the difference between the sale price and the value at exercise is a capital gain or loss (IRS Topic 427).

The planning point: exercising an NSO is itself the big taxable event, even if you hold the shares afterward. People exercise, hold the stock hoping it rises, and discover they owe tax on money they never received in cash. If you exercise NSOs, plan for the tax bill from the exercise, not just from a later sale.

How are incentive stock options (ISOs) taxed?

ISOs are only available to employees, and they come with the best tax treatment and the most rules. At grant and at exercise, you generally owe no regular income tax. The catch: the spread between the strike price and the fair market value at exercise is added to your income for alternative minimum tax (AMT) purposes in the year you exercise (IRS Topic 427).

To get the full benefit, you must make a qualifying disposition: sell the shares more than two years after the grant date AND more than one year after the exercise date. If you meet both holding periods, your entire gain (sale price minus strike price) is long-term capital gain. Miss either one and you have a disqualifying disposition: the bargain element at exercise becomes ordinary income (capped at your actual gain if you sold for less), and only the remaining appreciation is capital gain (IRC Section 422).

Three structural limits matter:

1. The $100,000 rule. Only $100,000 of grant-date value in ISOs can become exercisable for the first time in any calendar year. Anything above that is treated as an NSO (IRC Section 422(d)).

2. The strike price floor. The option price must be at least 100% of the fair market value on the grant date, and 110% if you own more than 10% of the company (with a maximum five-year term in that case).

3. The employment clock. You generally must exercise within three months of leaving the company (one year if you leave due to disability) or the ISO loses its favorable treatment.

ISO vs NSO at a glance

Can you make an 83(b) election on equity comp?

The 83(b) election lets you pay tax on restricted stock at grant instead of at vesting, which pays off if the stock rockets afterward. The election must be filed within 30 days of the transfer, it is irrevocable without IRS consent, and if you forfeit the shares you get no deduction for the tax you already paid (IRC Section 83(b)).

Here is the critical boundary: you cannot make an 83(b) election on RSUs. An RSU is an unfunded promise to deliver stock later, not a transfer of property, so there is nothing to elect on. The 83(b) election applies to actual restricted stock grants and to early-exercised options (where you exercise unvested options and receive restricted shares). Startup employees who early-exercise options at a low valuation and file an 83(b) within 30 days lock in a tiny tax bill at grant; miss the 30-day window and the opportunity is gone permanently.

What is QSBS and why does it matter for equity comp?

Qualified small business stock (QSBS) under IRC Section 1202 is the single biggest tax break available to startup equity holders, and it must be set up years before a liquidity event. If you hold QSBS and sell at a gain, you can exclude a large portion of that gain from federal income tax entirely.

For stock issued after July 4, 2025, the One Big Beautiful Bill Act created a tiered system: a 50% exclusion after holding three years, 75% after four years, and 100% after five years. The exclusion is capped at the greater of $15 million or 10 times your basis, per taxpayer per company ($7.5 million if married filing separately), with inflation indexing starting in 2027. The company must be a domestic C corporation with no more than $75 million in gross assets when the stock is issued. The portion of gain that is not excluded is taxed at a 28% rate plus the 3.8% net investment income tax, so the effective federal rates work out to about 15.9% at three years, 7.95% at four years, and 0% at five years.

For stock issued on or before July 4, 2025, the old rules still apply: 100% exclusion only after more than five years, capped at $10 million or 10 times basis, with a $50 million gross-asset threshold. The new tiers do not reach back to old stock, which is why the date your shares were issued matters enormously.

QSBS has strict requirements (C corporation status, original issuance, active business, no disqualifying redemptions), so confirm eligibility well before you need it. We cover this in depth in our QSBS guide.

What should you do before an IPO or acquisition?

Liquidity events reward planning done before they happen. Once the transaction closes, most planning options close with it. The moves that matter: confirming your QSBS eligibility and holding-period math years out, timing discretionary sales across tax years to manage bracket creep, donating appreciated shares to a donor-advised fund before the liquidity event (you deduct the fair market value and never pay tax on the appreciation), and making sure your withholding and estimated payments cover the real bill.

One specific trap: the installment sale method, which spreads gain across years when a buyer pays over time, is not available for stock traded on an established securities market. It can work for a private-company buyout paid in installments, but not for selling public shares after an IPO (IRS Publication 537).

How do state taxes and cross-border situations fit in?

Everything above is federal. States layer their own income tax on equity events, and the sourcing rules vary: some states tax RSUs based on where you worked during the vesting period, not where you live at vest. If you moved states (or countries) between grant and vest, or between vest and sale, more than one jurisdiction may claim a piece. For internationally mobile employees, RSU and option income can be taxable in multiple countries with treaty relief available but not automatic. This is where generic advice breaks down and your actual timeline matters, so map your work locations against each equity event before you file.

Updated October 14, 2026.

This article is free educational content, not tax advice for your specific situation. If you want a plan built around your actual numbers, that is what our paid tax planning engagements do.