Editor’s Note: This article was originally published in 2021 and has been updated to reflect current federal tax rates and planning considerations as of 2026.
Nonqualified stock options (NSOs), also called nonstatutory stock options, are a common form of equity compensation. Unlike incentive stock options, NSOs do not receive the same special tax treatment, but they can offer greater flexibility.
For most NSOs without a readily determinable fair market value at grant, exercising the option generally creates ordinary compensation income equal to the difference between the stock’s fair market value at exercise and the exercise price. If you continue to hold the shares after exercising, subsequent appreciation or loss generally results in a capital gain or loss when the shares are eventually sold. The IRS provides additional guidance on the tax treatment of nonstatutory stock options.
Deciding when to exercise NSOs involves more than predicting the company’s stock price. Taxes, cash needs, portfolio concentration, risk tolerance, expiration dates, and your broader financial goals should all factor into the decision.
When Should You Exercise and/or Sell?
The first step in deciding when to exercise is to look at which NSOs are vested and eligible to exercise. Generally, exercising an option when the current stock price is below the exercise price (often referred to as being “underwater”) would not provide an economic benefit, because the shares could be purchased in the market for less than the exercise price. Some other factors to consider:
- Advantages and disadvantages of waiting:
- What are your expectations of your company’s growth and stock appreciation?
- Do you believe it has reached its peak?
- Stock option expiration date:
- Do you have time to wait or is the expiration date looming?
- Current and future financial needs:
- Are you considering selling early because you need to raise cash now for events such as buying a new home or paying for your child’s college tuition?
- Current and potential future tax situation:
- Do you anticipate being in the same, lower, or higher income bracket when you exercise?
- Risk tolerance:
- Are you willing to tolerate the potential ups and downs of the stock market?
- Would you prefer a more conservative investment or do you believe an alternative investment will appreciate at a higher rate?
- Does your portfolio need risk diversification (if the majority of your investments are in your company’s stock)?
Executives with significant company stock may also want to evaluate diversification alongside their tax and charitable goals. Depending on the circumstances, charitable giving strategies involving appreciated stock may provide another way to incorporate concentrated holdings into a broader financial plan.
Because exercising NSOs can affect taxable compensation, investment exposure, and portfolio concentration, the decision should be evaluated as part of broader wealth and tax planning rather than based solely on the current stock price.
What Are Your Choices For Exercising?
There are three basic ways to exercise stock options. You can pay cash, use company stock you already own, or execute a “cashless exercise”. We will describe and illustrate two of those choices – cash and “cashless exercise”.
Paying cash to exercise your options is the least complicated method. You give your employer the cash required to purchase the options (number of options multiplied by the option price). Federal taxes will also be required to be paid.
A stock option plan may also allow option holders to exercise their options using the “cashless exercise” method. Your employer will make arrangements with a brokerage firm, which advances the money needed to buy the stock. The brokerage firm sells the required amount of stock to cover the option cost and taxes owed immediately. There is no cash outflow when this method is used.
NSO Exercise Examples: Comparing Exercise Timing
The following examples illustrate how the timing of an NSO exercise can affect taxes, cash requirements, and investment outcomes. They are hypothetical and are intended to demonstrate the mechanics of different exercise strategies rather than recommend a particular approach.
Assume you have 10,000 vested NSOs with a $10 exercise price that expire in 10 years. The total exercise cost is therefore $100,000. For purposes of the examples, assume the stock price is $10.60 in Year 1, $14.19 in Year 5, and $18.98 in Year 10.
The examples assume the taxpayer is subject to the 37% top federal ordinary income tax rate for 2026. They also assume the NSO exercise spread is subject to the 1.45% employee Medicare tax and 0.9% Additional Medicare Tax, for a combined illustrative federal income and Medicare tax rate of 39.35% on the exercise spread. The examples assume the taxpayer has already exceeded the Social Security wage base for the year, so Social Security tax is not included. For 2026, the Social Security wage base is $184,500.
If shares are held after exercise, subsequent appreciation is assumed to qualify for the 20% long-term capital gains rate. For purposes of illustrating a high-income taxpayer, the examples also assume the 3.8% Net Investment Income Tax applies to those investment gains, producing a combined illustrative rate of 23.8% on post-exercise appreciation. NIIT does not apply to the compensation income recognized on exercise because wages are excluded from net investment income.
To illustrate the cost of committing capital before the options expire, the examples assume a 6% annual financing or opportunity cost. Actual borrowing costs and investment returns will vary. State and local taxes, transaction fees, and other individual circumstances are excluded for simplicity.
If shares are held after exercise and later sold at a gain, investors should also consider how the sale fits into their broader investment tax picture. Higher-income taxpayers may want to understand whether the Net Investment Income Tax could affect investment gains or other portfolio income.
1. Exercise in Year 1 and Sell in Year 10
At a stock price of $10.60, exercising 10,000 options with a $10 exercise price creates a $6,000 compensation spread:
($10.60 − $10.00) × 10,000 = $6,000
Using the illustrative 39.35% federal income and Medicare tax rate, the tax associated with the exercise is approximately $2,361.
The investor therefore needs approximately $102,361 to exercise the options and cover the assumed federal taxes.
The investor’s tax basis in the 10,000 shares becomes approximately $106,000, or $10.60 per share. If the shares are later sold in Year 10 for $18.98 per share, the sale generates proceeds of $189,800 and a post-exercise capital gain of $83,800.
At the illustrative 23.8% federal long-term capital gains and NIIT rate, tax on that gain would be approximately $19,944.
Exercising this early also commits more than $102,000 of capital nine years before the assumed sale date. At an illustrative 6% annual financing or opportunity cost, that early commitment can significantly affect the relative economics of exercising early versus waiting.
2. Exercise in Year 5 and Sell in Year 10
At a stock price of $14.19, the compensation spread is:
($14.19 − $10.00) × 10,000 = $41,900
At the illustrative 39.35% rate, federal income and Medicare taxes on the exercise spread would be approximately $16,488.
The investor would therefore need approximately $116,488 to exercise the options and cover the assumed taxes.
The tax basis in the shares becomes approximately $141,900. If the stock is sold in Year 10 for $18.98 per share, the post-exercise capital gain would be approximately $47,900.
At the illustrative 23.8% rate, federal capital gains tax and NIIT on that gain would be approximately $11,400.
Compared with exercising in Year 1, this strategy delays the cash commitment and recognizes less post-exercise appreciation as capital gain.
3. Exercise and Sell in Year 10
If the options are exercised and the shares are sold immediately in Year 10 at $18.98 per share, the compensation spread is:
($18.98 − $10.00) × 10,000 = $89,800
At the illustrative 39.35% federal income and Medicare tax rate, taxes on the exercise spread would be approximately $35,336.
Because the shares are sold immediately after exercise at approximately the same fair market value used to determine the compensation income, there is generally little or no additional capital gain from the exercise-and-sale transaction itself.
This strategy also avoids committing the $100,000 exercise cost years in advance, although it results in a larger amount being taxed as compensation income at exercise.
| Strategy | Exercise Spread | Approx. Exercise Tax | Post-Exercise Gain | Approx. Tax on Gain |
|---|---|---|---|---|
| Exercise Year 1 | $6,000 | $2,361 | $83,800 | $19,944 |
| Exercise Year 5 | $41,900 | $16,488 | $47,900 | $11,400 |
| Exercise & Sell Year 10 | $89,800 | $35,336 | Minimal/none* | Minimal/none* |
Assumes the stock is sold at approximately the same fair market value used to calculate compensation income at exercise. Actual results will vary.
These examples illustrate why delaying exercise can sometimes produce a stronger economic result when the stock continues to appreciate: the option holder retains the leverage provided by the options and delays committing cash to the exercise price and related taxes. However, that does not mean waiting until expiration is always the best strategy.
Exercising earlier may be appropriate when an investor wants to begin the capital gains holding period, recognize compensation income earlier rather than potentially at a higher future stock price, diversify over time, address an approaching expiration date, or pursue other financial or tax-planning objectives. The appropriate strategy depends on the stock’s performance, tax rates, liquidity needs, portfolio concentration, risk tolerance, and the terms of the option plan.
Cashless Exercise Example
A cashless exercise can allow an option holder to exercise NSOs without providing the full exercise price in cash. Typically, a broker sells enough shares at the time of exercise to cover the exercise price, applicable taxes, and transaction costs. The investor may then retain or sell any remaining shares.
For example, if 10,000 NSOs with a $10 exercise price are exercised when the stock is worth $18.98 per share, the shares have a total market value of $189,800. The $89,800 spread is generally treated as compensation income. Using the illustrative 39.35% federal income and Medicare tax rate above, approximately $35,336 of federal tax would be associated with the exercise.
Before transaction costs, approximately $135,336 would therefore need to be covered by the transaction—the $100,000 exercise price plus approximately $35,336 of assumed federal taxes. Based on these simplified assumptions, approximately 7,130 shares would need to be sold to cover those amounts, leaving approximately 2,870 shares before considering transaction costs or other adjustments.
Actual cashless exercise mechanics, withholding, share quantities, and transaction costs will depend on the employer’s stock plan, brokerage arrangements, the stock price at execution, and the taxpayer’s individual circumstances.
Coordinate Your Stock Option, Tax, and Investment Strategy
There is no single exercise strategy that is appropriate for every NSO holder. The right timing depends on factors including the option’s expiration date, current stock price, expected appreciation, tax situation, liquidity needs, portfolio concentration, and tolerance for investment risk.
Exercising company stock options can also affect more than your current-year tax bill. Holding additional company stock may increase portfolio concentration, while selling shares can create capital gains and affect your broader investment and financial strategy.
Proactive individual tax planning can help you understand the tax consequences of exercising and selling NSOs.
If company stock represents a significant part of your overall wealth, talk with an LBMC wealth advisor about coordinating your stock-option decisions with diversification, retirement, charitable, and long-term financial goals.
LBMC tax tips are provided as an informational and educational service for clients and friends of the firm. The communication is high-level and should not be considered as legal or tax advice to take any specific action. Individuals should consult with their personal tax or legal advisors before making any tax or legal-related decisions. In addition, the information and data presented are based on sources believed to be reliable, but we do not guarantee their accuracy or completeness. The information is current as of the date indicated and is subject to change without notice.
