ISOs vs. NSOs: Which Are Better?

I’ve golfed all my life. Over the years, I’ve learned many things about the game, but the most important lesson is thinking through your situation. Many factors come into play, whether it’s wind, your lie between the rough and fairway, how warm it is outside, the conditions of the course, and more. I’ve learned that each of these components is critical.

The same goes for the different components you need to factor in when it comes to employee stock options.

There are two common types of employee stock options: incentive stock options (ISOs) and non-qualified stock options (NSOs). Each allows you to purchase company stock at a certain price. But it’s important to understand the differences in tax treatment, terms, and eligibility.

Understanding ISOs

Incentive stock options tend to be the more complex employer stock option, but they potentially offer favorable tax treatment. Here is what you need to know:

1. Eligibility: ISOs can only be granted to company employees. Consultants, board members, contractors, and other non-employees cannot receive ISOs.
2. Tax Advantages: When the ISOs are exercised, there is no immediate tax liability on the “bargain element.” The bargain element is the difference between the exercise price and the stock’s fair market value when it comes time to exercise. If certain requirements are met, you will receive favorable tax treatment of long-term capital gains rates when you sell the stock; this tends to be a more effective tax rate than ordinary income tax rates.
3. Holding Requirement: To receive the most favorable tax treatment, you must hold the stock for at least one year after the exercise date and at least two years after the grant date. (As a reminder, the grant date is a promise from the company for the options, and no tax implications occur. The vesting date typically is one year after the grant date. This is when you can legally exercise your options.)
4. Alternative Minimum Tax (AMT): The bargain element for employer options is added back to your income for that tax year, which may trigger AMT. Depending on your income level, you may pay the AMT versus your regular tax that year.

Let’s put all of this together in an example: Bill was granted his ISOs on June 1, 2020, with a $10 strike (exercise) price. This would mean his vesting date was June 1, 2021, with no tax event since Bill didn’t exercise his options. Bill exercised his options on June 1, 2023, and the stock’s fair market value was $50. This means the bargain element was $40 (fair market value on the exercise date $50 – exercise price $10). This year, Bill sold his shares on June 2, 2024, for $100. In the end, Bill was able to recognize long-term capital gains rates on $90 (fair market value on sale date $100 – exercise price $10). Since he held the stock two years after the grant date and one year after the exercise date, he would recognize favorable tax treatment.

Understanding NSOs

Non-qualified stock options are simpler and more flexible, but they don’t quite offer the same potential tax advantage. Here is what you need to know:

1. Eligibility: NSOs can be granted to anyone. This includes non-employees like contractors and consultants.
2. Tax Treatment: When the NSOs are exercised, they are taxed as ordinary income. The difference between the exercise price and fair market value of the stock on the date you exercise equals ordinary income per share. If you sell your shares after one year of holding from the exercise date, it’s taxed at long-term capital gains rates. But if you sell before a year after the exercise date, you’re taxed at short-term capital gains rates (ordinary income).
3. No Specific Holding Requirement: Unlike ISOs, NSOs have no special holding period.
4. No AMT Concerns: Exercising NSOs doesn’t create potential AMT issues.

Let’s put all of this together in an example: Katie was granted her options on June 1, 2020, with a strike (exercise) price of $10. No tax implications occurred on the grant date. One year later was the vesting date, June 1, 2021. Again, there were no tax implications on the vesting date since Katie didn’t exercise her options. On June 1, 2023, the options were exercised when the fair market value was $50, which means she was taxed $40/share as ordinary income (fair market value on the exercise date $50 – exercise price $10). Katie waited over a year to sell her shares, and on June 2, 2024, the fair market value was $100/share. When she sold, she recognized long-term capital gains of $50/share (difference between fair market value on sale date $100 – fair market value on the exercise date $50).

Which Option Is Better?

Your individual circumstances play a big role, as does your position at a company. You may not have a choice as to what kind of equity option you are granted, but each has pros and cons.

For employees who are confident in a company’s outlook and can meet the holding requirement, ISOs may offer you more favorable tax treatment. For individuals who have a short-term outlook, NSOs are potentially a simpler solution, as the tax advantages for ISOs may not apply.

Main Takeaway

Both ISOs and NSOs can be beneficial in a compensation package. Each has its differences with eligibility, tax treatment, and holding requirements, but it’s important to keep in mind the tax due for the year you exercise and sell your stock. At the end of the day, understanding your employer options will give you insight into key decisions that can impact your financial journey.

The opinion of the author is subject to change without notice and must be considered in conjunction with relevant regulation, as well as subsequent changes in the marketplace. Any information from outside resources has been deemed to be reliable but has not necessarily been verified. Each individual has unique circumstances to which this information may or may not be relevant. Under no circumstances will this information constitute an offer to buy or sell and it does not indicate strategy suitability for any particular investor. Past performance is not indicative of future results.