Incentive vs. non-qualified stock options

Also called ISO, NSO, NQSO, employee stock options

Employer grants giving the right to buy company shares at a fixed price; incentive and non-qualified options differ mainly in how they are taxed.

What it means

An employee stock option gives the right, but not the obligation, to buy company shares at a set price, called the strike or exercise price, usually after vesting and before an expiration date. Options are valuable only if the share price rises above the strike price. The difference between the market price and the strike price at exercise is called the spread.

Non-qualified stock options, or NSOs, are taxed as ordinary income on the spread when they are exercised, and the employer typically withholds taxes. Incentive stock options, or ISOs, can be offered only to employees. Exercising them generally creates no regular income tax, but the spread can trigger the alternative minimum tax. If ISO shares are held at least two years from grant and one year from exercise, the entire gain on sale can be taxed as a long-term capital gain.

Example

Suppose an employee exercises 1,000 options with a $10 strike price when the stock is $30. The spread is $20,000. With NSOs, that $20,000 is taxed as ordinary income in the year of exercise; with ISOs, it is not regular taxable income then, but it may count toward the alternative minimum tax.

How it’s used

Evaluating startup or growth-company job offers
Deciding when to exercise and sell
Planning around the alternative minimum tax

Strengths and weaknesses

Strengths

Large upside if the company’s stock rises
ISOs can turn gains into long-term capital gains
Exercise timing gives some control over taxes

Weaknesses

Worthless if the share price stays below the strike price
Exercising can require significant cash and create taxes before any sale
ISOs can trigger the alternative minimum tax
Options usually expire within a set window after leaving the employer

Educational information only, not financial, tax or legal advice. Rules, limits and rates change; check the IRS, your lender or plan, or a qualified professional before acting.