When and how are nonqualified stock options taxed?
You pay taxes when you exercise nonqualified stock options (NQSOs). The taxable income that you recognize is the difference between the stock price on the exercise date and your exercise price.
Example: Your NQSOs have an exercise price of $10 per share. You exercise them when the price of your company stock is $12 per share. You have a $2 spread ($12 – $10) and thus $2 per share in ordinary income.
Your company will withhold taxes—income tax, Social Security, and Medicare—when you exercise NQSOs. Specifically:
- The income at exercise is subject to mandatory supplemental wage withholding, unless you are a consultant.
- The income is also subject to Social Security and Medicare taxes, along with any applicable state taxes.
- The income and withholding taxes will appear on your W-2 in the appropriate boxes, as illustrated in another FAQ.
Example: Your exercise price for 1,000 NQSOs is $12 per share. The market price is $20 at exercise. Ordinary income of $8,000 [($20 - $12) x 1,000] is added to your taxable income and is subject to withholding at exercise.
This tax treatment is the same for all types of exercises. The amount of taxable income and the withholding calculation are based on the stock's value when your company initiates the share-transfer process (usually the vesting date) and not when the stock appears in your brokerage account.
In the calculation for the amount of compensation income, the spread is not reduced by any brokerage commission if you sell the stock in a same-day/cashless exercise. See the Tax Center for FAQs showing how you report this stock sale on your tax return.
Capital Gains From Sale After Holding
When you sell the shares acquired at exercise, you are taxed on your capital gains, as with any stock you purchase. Capital gains tax applies on the amount of your gains above your tax basis after exercise. Long-term capital gains rates apply when you hold the stock more than one year after exercise.
Example: You receive a grant of NQSOs and exercise them after vesting.
- Your exercise price is $12.
- The market price (used to calculate the spread at exercise) is $18.
- You sell the stock when the price is $26.
- You have $6 per share ($18 – $12) of ordinary income at exercise.
- You sell the shares more than one year later.
- You have $8 ($26 – $18) of capital gains at sale.
- The capital gains are taxed at 15% or 20%, depending on your income.