The tax treatment of equity compensation depends heavily on what you received and when you act. RSUs, ISOs, and NSOs can all look similar on an offer letter while creating very different tax consequences later.
NSOs
When you exercise a non-qualified stock option, the spread between the strike price and the current fair market value is generally treated as ordinary income. That income usually appears on your W-2 and is subject to income-tax withholding and payroll tax.
From that point forward, any additional gain or loss is treated the way it would be if you had purchased the stock at the market price on the exercise date.
The practical risk is straightforward: you can create a tax bill before you have actually turned the stock into cash. In many cases it is prudent to sell enough shares immediately to cover the tax liability.
ISOs
Incentive stock options are different. Exercise does not usually create regular ordinary income, but the spread at exercise can create AMT income.
If you hold the shares for more than one year after exercise and more than two years after grant, the eventual sale can qualify for long-term capital gains treatment. If you sell too soon, the favorable ISO treatment is lost and part of the gain is treated more like ordinary income.
ISOs can become especially tricky before an IPO or liquidity event because exercising early may reduce later AMT exposure, but it also means committing cash and taking real risk before the shares are liquid.
RSUs
Standard RSUs are usually taxed as ordinary income when they vest. That value is typically subject to withholding and appears on your W-2.
True restricted stock can sometimes allow an 83(b) election, which means electing to recognize income earlier rather than waiting for vesting. That can work well if the value is still low and the upside is large, but it can also backfire if the stock falls or never vests.
As with NSOs, the practical issue is that a tax bill can arrive before you have diversified or sold enough shares to cover it.
Quick comparison
| Event | NSO | ISO | RSU | Restricted stock with 83(b) election |
|---|---|---|---|---|
| Grant or issue | Usually no tax | Usually no tax | Usually no tax | Ordinary income at issue |
| Vesting | No tax | No tax | Ordinary income plus withholding | No additional ordinary income |
| Exercise | Ordinary income plus withholding | Potential AMT impact | Not applicable | Not applicable |
| Sale | Capital gain or loss after exercise | Capital gain or a mix of capital gain and ordinary income depending on holding period | Capital gain or loss after vesting | Capital gain or loss after issue |
Diversification still matters
Equity compensation often grows alongside your career, identity, and optimism about the company. That makes concentration risk easy to underestimate.
If a large share of your net worth is tied to one company, diversification is not a theoretical issue. It is part of protecting the rest of your life from one employer, one stock, or one liquidity outcome.