ISO vs RSU: Understanding Your Equity Compensation

Quick Answer

ISOs (Incentive Stock Options) and RSUs (Restricted Stock Units) are two forms of tech equity compensation with different tax treatments. ISOs offer favorable long-term capital gains treatment but trigger Alternative Minimum Tax (AMT) risk if exercised before vesting. RSUs are taxed as ordinary income at grant/vest but simpler to manage and no exercise required. Choose your strategy based on income level, stock growth expectations, and tax bracket planning.

What Is an ISO?

An ISO (Incentive Stock Option) is the right to purchase company stock at a fixed price (grant price) in the future.[1] You receive the right but not the shares until you exercise.

Example: You receive an ISO grant of 1,000 shares at $10 strike price. Company IPOs at $50/share. You exercise (buy 1,000 shares at $10 = $10,000 cost) and own shares worth $50,000. Gain: $40,000.

Vesting: ISOs typically vest over 4 years with a 1-year cliff (you receive 25% after 1 year, then monthly for remaining 3 years).

Exercise window: You have 10 years from grant to exercise the option (per IRS rules). Some companies shorten this to 90 days after leaving.[1]

What Is an RSU?

An RSU (Restricted Stock Unit) is a promise to deliver shares at a future date (vesting), typically without you paying anything.

Example: You receive 1,000 RSUs at a grant price of $10 (for tax purposes). After 4 years of vesting, you automatically receive 1,000 shares worth $50,000 (assuming stock is at $50). No exercise required.

Vesting: RSUs follow the same 4-year schedule as ISOs (1-year cliff, then monthly/quarterly).

Taxes at vest: RSUs are taxed as ordinary income at vest date. If you receive 250 RSUs when stock is $50, you owe tax on $12,500 in income (your employer withholds shares for tax).

Tax Treatment: The Key Difference

ISOs: Favorable long-term capital gains (if qualified)

• Exercise: No immediate tax (critical difference from RSUs)
• Hold 1+ year after exercise + 2+ years from grant: Gain taxed as long-term capital gain (15-20% federal rate)
• Exercise immediately at grant: 10-year hold until expiration, but no upfront tax

Example:

• Grant: 1,000 ISOs at $10 strike
• Exercise at $50/share: No tax owed. Shares cost $10,000.
• Sell at $100/share (2+ years later): Gain of $90,000 taxed at 15% LTCG = $13,500 tax. Keep $76,500.

RSUs: Ordinary income tax

• Vest: Taxed as ordinary income at vest date (like a bonus)
• Sell: Additional capital gains tax only on appreciation after vest

Example:

• Grant: 1,000 RSUs at $10
• Vest when stock is $50: Ordinary income tax on $50,000 (25% bracket = $12,500 tax). Employer withholds.
• Sell at $100/share: Additional capital gain tax on $50,000 gain (15% LTCG = $7,500). Total tax: $20,000.

AMT (Alternative Minimum Tax) on ISOs

ISOs trigger AMT if you exercise and hold without selling immediately. AMT is a parallel tax system that can exceed regular income tax.[2]

AMT calculation on ISOs:

• Exercise 1,000 ISOs at $10 strike. Stock worth $50 at exercise.
• AMT income = spread between grant price and exercise price × shares = ($50 - $10) × 1,000 = $40,000
• AMT rate: 26-28%
• AMT owed: $40,000 × 26% = $10,400 (paid upfront)

If you owe $10,400 in AMT but only $5,000 in regular income tax, you pay $10,400 (the higher amount).

AMT trap: If the stock price drops 50% after you exercise (and pay AMT), you may owe tax on paper gains that vanish. No refund exists—you're stuck.

Mitigation:

• Exercise only shares you plan to hold long-term (3+ years)
• Avoid exercising large blocks in high-appreciation scenarios unless you have cash to absorb AMT
• Exercise in two tranches: some now, some later (spreads AMT over 2 years)

When ISOs Make Sense

ISOs are optimal if:

1. You expect stock appreciation > 50% over the exercise horizon. The long-term capital gains advantage (15% vs 25-37% ordinary income) offsets complexity.
2. Your income is moderate ($150K-$250K range). High earners face 37% ordinary income tax, making the LTCG advantage substantial.
3. You can afford AMT payments. Liquid cash to pay AMT upfront without selling shares is essential.
4. You plan to hold shares long-term (3+ years post-exercise). Holding demonstrates belief in the company.

When RSUs Make Sense

RSUs are simpler and often better if:

1. You have low income (<$150K). The ordinary income tax bracket is 22-24%, not far from capital gains (15%), reducing LTCG advantage.
2. You can't afford AMT. RSUs have no AMT risk; you can sell shares immediately at vest to cover taxes.
3. You want simplicity. No exercise decision, no 10-year window tracking, no AMT calculations.
4. Stock appreciation is uncertain. If you expect modest appreciation (20-30%), RSU simplicity wins.

Exercise Strategies for ISOs

Exercise early (at grant):

• Pro: Locks in favorable LTCG treatment immediately (2-year clock starts now).
• Con: You pay $10,000 upfront for shares you don't own yet. Risky if you leave before vesting.

Exercise at vesting completion:

• Pro: You know the vesting is complete; less forfeiture risk.
• Con: Appreciation is larger, AMT is bigger. Stock may be at $80 instead of $20, triggering AMT of $56,000.

Exercise in stages:

• Pro: Spreads AMT across multiple years, reducing annual AMT burden.
• Con: Requires discipline and planning across multiple tax years.

Hold and exercise after IPO:

• Pro: Post-IPO liquidity makes it easier to cover AMT and exercise costs.
• Con: You may have missed early appreciation if the company was already valued highly pre-IPO.

Selling and Holding Strategies

ISOs: Once exercised, hold for 1+ year from exercise AND 2+ years from grant for LTCG treatment.

Selling before qualified holding: If you sell less than 2 years from grant, the spread at exercise is ordinary income (disqualifying event). Example: Exercise at $40 gain, sell at $50 gain—the $40 is ordinary income, remaining $10 is LTCG.

RSUs: No holding requirement. Vest at ordinary income, sell immediately if you want. No LTCG timing rules.

Startup vs Public Company Equity

Startup ISOs: Higher risk/reward. Stock value is illiquid; you can't exercise and hold easily. AMT is a killer if the stock doesn't appreciate as expected. Many startup employees exercise ISOs, then the company fails, and they've paid AMT on zero gain.

Public company ISOs/RSUs: Lower risk. Liquid, easy to sell. AMT is manageable because you can sell to cover taxes.

Rule of thumb: Startups should consider avoiding ISOs for non-C-level employees (too risky). RSUs with accelerated vesting (3-year cliff) are fairer to employees who might leave.

Spread Calculation and Exercise Pricing

The "spread" is the difference between the strike price and the fair market value (FMV) at exercise.

Example:

• Grant: 1,000 ISOs at $20 strike
• FMV at exercise: $50
• Spread: $30 per share
• Taxable spread for AMT: $30 × 1,000 = $30,000

For RSUs, the FMV at vest date is taxable income (ordinary rate), spread is capital gains.

Recommended Calculators

• ISO vs RSU Calculator — Model after-tax outcomes for both equity types
• Equity Comp Analyzer — Compare packages with different equity mixes
• Startup Equity Dilution Calculator — Calculate dilution impact on ownership
• Capital Gains Tax Calculator — Plan selling strategy and tax liability

Frequently Asked Questions

Can I exercise ISOs if I've left the company? Only within the exercise window (usually 90 days to 10 years from grant). After you leave, the window shrinks to 90 days in most plans. You must exercise immediately or forfeit.

What happens if my company goes public while I hold ISOs? Your ISOs remain ISOs post-IPO (favorable tax treatment persists). You can exercise and hold (or sell) easily now that stock is liquid. AMT is more manageable post-IPO.

If I get both ISOs and RSUs, should I prioritize exercising ISOs first? Generally, yes. ISOs have a 10-year exercise window and favorable tax treatment; RSUs have no exercise decision. Exercise ISOs when you have cash and confidence in stock appreciation. RSUs are automatic.

How do I avoid AMT surprise? Model AMT before exercising. If the spread is $100,000 and you'll owe $26,000-$28,000 in AMT, ensure you have cash. Use an accountant experienced with ISOs.

Sources

[1] Internal Revenue Service. (2026). "Incentive Stock Options (ISOs)." https://www.irs.gov/publications/p525

[2] Internal Revenue Service. (2026). "Alternative Minimum Tax (AMT) Computation." https://www.irs.gov/publications/p559

[3] Securities and Exchange Commission. (2026). "Equity Compensation and Exercise." https://www.sec.gov/cgi-bin/browse-edgar

[4] American Bar Association. (2026). "Guide to Stock Options and Equity Compensation." https://www.americanbar.org/

[5] Tax Foundation. (2026). "Long-Term Capital Gains Tax Rates." https://taxfoundation.org/data/all/federal-income-tax-rates/