Non-qualified stock options (NSOs, sometimes NQSOs) are the most common kind of stock option outside of early-stage startups, and they are also given to advisors and contractors. They are simpler than ISOs, with no AMT, but the tax arrives at a moment people often do not expect.
Taxed as pay when you exercise
When you exercise, the spread (market value minus strike price, times shares) is ordinary income. For employees it is added to your W-2 and is subject to income tax, Social Security and Medicare, just like a bonus.
| Example exercise | Amount |
|---|---|
| 5,000 options, strike price $10 | $50,000 to exercise |
| Market value: $30 a share | $150,000 |
| Ordinary income at exercise | $100,000 |
Your cost basis in the shares becomes their market value on the exercise date ($30 here). If you sell later, the difference is a capital gain or loss: long-term if you held more than a year.
Withholding often falls short
Like RSUs, NSO income is usually withheld at the flat 22% federal supplemental rate. If you are in a higher bracket, the rest is due when you file. A large exercise can also push you into a higher bracket for the whole year.
Ways to manage the tax
- Spread exercises across tax years so the income lands in lower brackets.
- Exercise in a lower-income year, such as a year with a sabbatical, a move between jobs or a business loss.
- Exercise and sell at once if you cannot afford the tax on shares you keep; there is little or no extra gain.
- Watch the expiration date and your post-termination exercise window. Options usually expire 10 years after grant, and often within 90 days of leaving.
Exercising private company options
If the company is private, you owe tax on the spread even though you cannot sell the shares to pay it. Before exercising, model the tax and the cash you need for both the strike price and the tax bill.