Stock compensation is a powerful way to build wealth, but it can also create tax bills before you see any cash. Knowing how employee stock options, restricted stock units (RSUs) and employee stock purchase plans (ESPPs) are taxed helps you avoid surprises and plan smartly.
How stock-based pay generally works
Many employers pay part of compensation in shares or options. That creates potential upside if the stock rises, but taxes depend on the type of award and when you exercise, vest or sell. In short: timing matters.
Employee stock options: ISOs vs NSOs
- Non-qualified stock options (NSOs or NQSOs): When you exercise NSOs, the difference between market price and strike price (the “spread”) is taxed as ordinary income. That amount is reported on your W-2. Additional tax or capital gains depend on when you later sell the shares.
- Incentive stock options (ISOs): If you follow the holding rules (hold at least two years from grant and one year from exercise), gains on sale can be taxed as long-term capital gains — potentially a big benefit. But exercising ISOs can trigger the alternative minimum tax (AMT) in the year of exercise even if you haven’t sold the shares, so plan accordingly.
- Practical note: Exercising options may require cash and could create an immediate tax bill. Consider sell-to-cover, where you sell some shares at exercise to pay taxes, or plan ahead with reserve cash.
Restricted stock units (RSUs)
RSUs give you company shares when they vest. They are simple to understand but taxable right at vesting:
- At vest, the fair market value of the shares is treated as ordinary income and typically subject to payroll withholding (federal, state and FICA).
- After vesting, any later gain or loss from sale is treated as a capital gain or loss based on how long you hold the shares after vest.
- Important: RSUs are generally not eligible for an 83(b) election. That election only applies when you receive actual restricted shares at grant and want to accelerate taxation to the grant date.
Employee stock purchase plans (ESPPs)
ESPPs let employees buy company stock at a discount, often with a “lookback” that uses the lower of grant or purchase price to calculate the discount. Taxes depend on how long you hold the shares after purchase:
- Qualifying disposition: If you meet the holding periods (usually two years from grant and one year from purchase), part of the gain is taxed as ordinary income (related to the discount) and the remainder is taxed as capital gain — often favorable.
- Disqualifying disposition: If you sell earlier, the discount is taxed as ordinary income at sale, and any additional gain may be capital gain.
Practical tax planning tips
- Estimate tax before you act: Exercise or vesting can trigger taxes even if you don’t sell. Run the numbers or get help from a tax pro to know your exposure.
- Set aside cash or use sell-to-cover: Companies often offer automatic withholding or sell-to-cover for RSUs and exercises. If not, save money to pay taxes or make estimated tax payments.
- Watch AMT with ISOs: If you exercise many ISOs, work with a tax advisor to model AMT impact and timing.
- Document everything: Keep grant letters, exercise confirmations, and brokerage statements. Accurate cost basis is crucial for calculating gains and losses.
- Talk to a professional: Stock awards can be complex. A CPA or financial planner can help you time exercises and sales to match tax goals and cash needs.
Bottom line
Stock compensation can be a major wealth-builder, but taxes often arrive before you see cash. Understand the rules for options, RSUs and ESPPs, plan for tax liabilities, and get advice when needed so you keep more of the upside.