Unlike with NQSOs, with ISOs there is no federal income-tax withholding at exercise (even with a same-day sale), and no Social Security and Medicare tax is owed or withheld. The American Jobs Creation Act (Section 251) specifically excludes ISO and ESPP gains at exercise or sale from this tax withholding. Other than Pennsylvania, states follow the federal rules. This does not mean you have no taxable income at exercise or sale. Rather, income tax is paid either when you file your tax return or through estimated tax payments.

Alert: You therefore need to plan for future taxes that you will owe with your return. Consider putting aside the taxes you will owe, and also think about whether you need to make estimated tax payments.

For an annotated diagram of what will appear on your W-2 after you exercise incentive stock options, see a related FAQ.