Unlike with NQSOs, with ISOs there is no federal income-tax withholding at exercise (even with a same-day sale or when you trigger the AMT), and no Social Security and Medicare taxes are owed or withheld. The American Jobs Creation Act (Section 251) specifically excluded 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 taxes that you will owe with your return and taxes you will incur at sale. 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.

Got another minute? Watch our quick take on the top five things you need to know about the taxation of ISOs.