Incentive Stock Options (ISOs): What Tech Employees Need to Know
Last reviewed: September 2026 · Educational, not individual advice
ISOs are taxed by how long you hold the shares. Sell within a year of exercise or two years of grant and the bargain element is ordinary income (a disqualifying disposition). Hold past both dates and the whole gain is a long-term capital gain (a qualifying disposition). The trade-off is AMT at exercise, and Maryland gives no lower rate.
If you work in tech or biotech in the DC metro, there is a good chance stock options are part of your pay. And if you have stared at your equity grant wondering what to actually do with it, you are not alone. Incentive Stock Options (ISOs) are one of the most valuable perks a company can offer and one of the most misunderstood. The wrong move can mean a surprise tax bill; the right one can mean thousands of dollars of difference in this illustration. Here is how they work.
The three stages of an ISO: grant, exercise, sale
Every ISO goes through three stages: you get them, you exercise them, and you sell the shares. Each stage has consequences.
Stage 1: your grant. The grant tells you the grant date, the number of options, the exercise price (strike price) you will pay per share, the vesting schedule, and the expiration date, usually 10 years from grant. Nothing is taxable at grant.
Illustrative example used throughout: Steven, a senior leader at a startup, is granted 1,000 ISOs at a $10 strike with a one-year vest. (Steven and his wife Grace are a hypothetical composite, not clients.)
Stage 2: exercising. Once vested, you may pay the strike price to convert options into shares. It is a choice. Think of a coupon: if the coupon says "buy a sandwich for $7" and the sandwich costs $5.50 at the counter, the coupon is useless. If the stock trades below your strike, the options are out of the money. If it trades above, they are in the money. In Steven's case the stock is now $20, so he pays $10,000 for shares worth $20,000. The $10,000 difference is the bargain element, and it drives everything that follows.
Stage 3: selling. Two paths, and the difference between them is real money.
Qualifying vs disqualifying disposition: the same $10,000, three ways
Disqualifying disposition (the more expensive route). If you sell before meeting both holding requirements, the bargain element is ordinary income at your regular rate. Any further gain after exercise is a capital gain, short- or long-term depending on how long you held after exercise. One small mercy: ISO disqualifying income is not subject to Social Security and Medicare tax.
Qualifying disposition (the tax-advantaged route). Hold the shares more than two years from the grant date and more than one year from the exercise date, and the entire gain from strike price to sale price is a long-term capital gain: 15% for most filers, 20% once 2026 taxable income passes $545,500 (single) or $613,700 (joint), plus the 3.8% net investment income tax above $200,000 / $250,000 of MAGI.
| Path | Ordinary income | Capital gain | Federal tax (illustrative) |
|---|---|---|---|
| Disqualifying: exercise and sell in the same year | $10,000 bargain element × 32% = $3,200 | $5,000 short-term × 32% = $1,600 | $4,800 |
| Disqualifying: sold 14 months after exercise but under 2 years from grant | $10,000 × 32% = $3,200 | $5,000 long-term × 15% = $750 | $3,950 |
| Qualifying: past both holding dates | $0 | $15,000 long-term × 15% = $2,250 | $2,250 |
In this illustration the qualifying path saves about $2,550 of federal tax on a $15,000 gain. Scale the share count up and the difference is what makes ISO planning worth doing.
The AMT trap, and why timing your exercise matters
There is one more wrinkle. If you exercise ISOs and still hold the shares at the end of the calendar year, the bargain element is added to your income for the alternative minimum tax. You may owe AMT in April on shares you have not sold, so the cash has to come from somewhere else. For 2026 the AMT exemption is $90,100 (single) or $140,200 (joint) and it phases out quickly above $500,000 / $1,000,000 of AMT income; the full table and a worked phaseout example are in our guide to the 2026 AMT exemption and phaseout.
One strategy worth knowing: exercise early in the calendar year. That gives you until December to see where the stock and your income land. If the AMT bill looks manageable, hold and start the clock on a qualifying disposition. If the stock has dropped or the AMT is too large, sell in the same year; that is a disqualifying disposition, but it erases the AMT preference. The silver lining either way is that AMT paid because of ISOs generally comes back as a credit against regular tax in later years.
Two rules that quietly turn ISOs into ordinary income
The $100,000 rule. Only $100,000 of ISOs, measured by fair market value at grant, may become exercisable for the first time in any calendar year. Options above that limit are treated as non-qualified stock options, taxed as ordinary income at exercise with payroll tax. Large grants that vest quickly hit this ceiling more often than people expect.
The three-month rule after you leave. To keep ISO treatment you generally must exercise within three months of leaving the company; most plans write this as a 90-day window. Exercise later, or let the plan convert the options, and they are taxed as non-qualified options. Anyone planning a job change with vested ISOs should put this date on the calendar before giving notice.
Does Maryland give you a lower rate on a qualifying disposition?
The qualifying disposition is a federal advantage. Maryland taxes capital gains as ordinary income at state and county rates (Montgomery County adds 3.2%), and since tax year 2025 adds a 2% surcharge on net capital gains when federal AGI exceeds $350,000. Maryland has no AMT, so the exercise itself creates no state bill, but the eventual sale is taxed the same whether it qualifies or not. For a DMV household the holding-period decision is about federal rates and how much single-stock risk you are willing to carry for another year.
The bigger picture: your job, your stock, your RSUs
The math above assumes the stock keeps going up. In reality you are also holding concentrated risk in the company that pays your salary. Before making any move on your ISOs, ask: Do I need the money now, or can I afford to wait? Am I comfortable with my job and a large share of my wealth tied to the same company? What does my tax situation look like this year versus the next few?
For Steven and Grace the ISO decision sits next to Grace's RSU vests at a public company, which push the couple's bracket up and shrink the AMT exemption in the same year. Our guides on what to do with the RSUs vesting alongside and on concentration risk in your employer's stock cover the other half of the picture.
ISOs can be a powerful wealth-building tool, but only with a plan. If you are not sure where to start, book a call and we will map your grants, holding dates, and AMT exposure together. See our services and the hub for tech employees.
FAQ: how ISOs are taxed
What is the difference between a qualifying and a disqualifying disposition?
A qualifying disposition is a sale more than two years after grant and more than one year after exercise; the whole gain is a long-term capital gain. A disqualifying disposition misses either date; the bargain element becomes ordinary income and only the gain after exercise is a capital gain.
Do I owe tax when I exercise ISOs?
Not regular income tax. Exercising ISOs is not a taxable event for regular tax, but if you hold the shares past December 31 the bargain element counts toward the alternative minimum tax. Depending on your income and the 2026 exemption, that can produce an AMT bill the following April with no cash from a sale.
Does Maryland tax ISO gains at capital gains rates?
No. Maryland taxes capital gains as ordinary income at state and county rates, and since tax year 2025 adds a 2% surcharge on net capital gains when federal AGI exceeds $350,000. The lower long-term rate on a qualifying disposition applies only to your federal return.
What happens to my ISOs if I leave the company?
Unvested options are usually forfeited. Vested ISOs generally must be exercised within three months of your departure to keep ISO treatment; many plans state 90 days. After that they are taxed as non-qualified options or expire, depending on the plan. Check your grant agreement before you resign.
Sources
- IRS Publication 525, Taxable and Nontaxable Income (statutory stock options)
- IRS Topic 427, Stock options
- Internal Revenue Code §422, Incentive stock options ($100,000 limit; three-month rule)
- Tax Foundation, 2026 federal brackets and capital gains thresholds (IRS Rev. Proc. 2025-32)
- Maryland Comptroller, Technical Bulletin 58, capital gains surcharge
Disclaimer: This article is for educational and informational purposes only and does not constitute investment, tax, legal, or insurance advice. ISO and RSU taxation depends on your individual circumstances; Steven and Grace are a hypothetical composite, not clients. Always consult a qualified tax professional before making equity compensation decisions.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
Securities and investment advisory services offered through LPL Enterprise (LPLE), a Registered Investment Advisor, Member FINRA/SIPC, and an affiliate of LPL Financial. LPLE and LPL Financial are not affiliated with Allset Wealth.