Incentive Stock Option (ISO)

What it means

An Incentive Stock Option (ISO) is a benefit offered by your employer that gives you the right to buy company stock at a set price. It is designed to reward employees by offering potential tax savings that are not available to everyone.

Unlike other types of options, you generally do not pay regular income tax when you buy the shares. However, you must follow strict rules about how long you keep the stock to get the full tax benefit. If you do not follow these rules, your tax savings may disappear.

A simple example

Imagine Sarah is granted options to buy 100 shares of her company at a strike price of $5 per share. After they vest (become hers to keep), she decides to exercise, which means she buys the 100 shares for $500 total. At that time, the fair market value (the current market price) is $10. Even though her shares are worth $1,000, she does not pay regular income tax on that $500 difference, known as the spread. If Sarah holds the shares for at least one year after exercising and two years from the grant date, her final profit is taxed at the lower capital gains rate.

Why it matters to you

• You could save money by paying a lower tax rate on your investment profits.
• You do not owe regular income tax the moment you buy the shares.
• You might be required to pay the Alternative Minimum Tax (AMT), which is a separate tax system designed to ensure high earners pay some tax.
• A tax professional can help you navigate these complex rules.

Common mistakes to avoid

• Selling your shares too soon, which turns your profit into higher-taxed ordinary income.
• Forgetting to set aside money for the AMT, which can be a surprise bill at tax time.
• Assuming all stock options work the same way, when ISOs have very specific requirements.

Words used on this page

Exercise: The act of buying the shares using your options. Strike Price: The fixed price you pay to buy each share. Fair Market Value (FMV): The price the stock would sell for on the open market today. Spread: The difference between the current market price and the price you paid for the shares. Alternative Minimum Tax (AMT): A secondary tax calculation that ignores certain deductions to ensure you pay a minimum amount of tax.