RSUs vs ISOs: Tax Treatment for Bay Area Tech Employees (2026)

Bay Area tech employees holding RSU grants and ISO packages face genuinely different tax treatment, and the gap between getting it right and getting it wrong can reach six figures in a single year. The mechanics are not complicated on paper, but the defaults your employer sets are almost always wrong. Most equity plans vest RSUs and auto-withhold at the flat supplemental rate of 22 percent federal (37 percent above $1 million in aggregate), which falls well short for a senior engineer in California sitting in the 37 percent federal bracket and the 13.3 percent state bracket. ISOs look like a gift at exercise because no regular income tax fires, but they create an AMT preference item that can generate a tax bill nobody planned for.

This guide covers the full comparison: ordinary income at vest for RSUs, the withholding gap and what to do about it, ISO mechanics from grant through disposition, AMT on ISO exercise, qualifying versus disqualifying disposition holding periods, the 83(b) election for early-exercise ISOs, OBBBA 2025 considerations, California sourcing on multi-state vesting moves, and a decision framework for evaluating your specific equity package. We work through these questions daily with tech employees at our equity compensation practice here in San Jose.

RSU Tax Mechanics: Ordinary Income at Vest

A restricted stock unit is a promise to deliver shares at a future date, contingent on continued employment and sometimes on performance milestones. From a tax standpoint, RSUs are simple in structure and often painful in execution. Under IRS Topic 427, RSU income is taxable as ordinary wages at vest, the moment the shares are delivered to you free of restrictions. The taxable amount equals the fair market value of the shares on the vest date, regardless of whether you sell immediately or hold.

Your employer is required to withhold federal income tax, Social Security (6.2 percent, up to the wage base), and Medicare (1.45 percent plus the 0.9 percent Additional Medicare Tax if your total wages exceed the threshold). California also withholds state income tax. The number that matters is the withholding rate your employer applies to the vest event, because that rate determines whether you owe a balance or get a refund at tax time.

The Sell-to-Cover Withholding Gap

Most equity plans default to "sell-to-cover," where the plan automatically sells enough shares at vest to cover the withholding obligation. The withholding obligation is calculated at the IRS supplemental wage rate: 22 percent federal for wages under $1 million in aggregate supplemental pay, 37 percent federal above $1 million. California withholds at its own supplemental rate.

Here is the problem. A senior software engineer or tech lead at a FAANG company earning $300,000 in base salary plus $200,000 in vesting RSUs sits in the 35 or 37 percent federal bracket and the 12.3 or 13.3 percent California bracket on that RSU income. If the plan sells shares to cover at the 22 percent federal supplemental rate, it is withholding roughly 35 to 36 percent (federal plus state combined) when the actual combined marginal rate for that employee is closer to 50 percent. The 14 to 15 percentage point shortfall on a $200,000 vest event means the employee owes $28,000 to $30,000 at filing, possibly including an underpayment penalty if estimated taxes were not paid quarterly.

The fix is not complicated: estimate your RSU income for the year, calculate the marginal tax rate on that income, compare it to the withholding rate the plan applies, and make quarterly estimated tax payments to cover the gap. Your plan may also allow you to elect a higher withholding rate directly. Either way, this is a planning problem with a clear solution, not a problem to discover in April.

ISO Tax Mechanics: No Event at Grant, AMT Trap at Exercise

Incentive stock options are governed by IRC Section 422 and work under a fundamentally different tax regime. Three events matter: grant, exercise, and sale. Each has a different tax consequence.

At grant: nothing happens for tax purposes. No income, no withholding, no AMT. The option sits unexercised.

At exercise: under regular income tax (the system most people think of as "income tax"), nothing happens either. You pay the exercise price, receive shares, and owe zero ordinary income tax on the spread between the exercise price and the fair market value. This is the statutory benefit of ISOs. However, that same spread, the difference between the FMV on the exercise date and the exercise price you paid, is an AMT preference item. It gets added to your alternative minimum tax income (AMTI). If your AMTI, after the AMT exemption, is high enough to generate an AMT liability exceeding your regular tax liability, you pay AMT. More on this below.

At sale: the tax character of your gain depends entirely on whether the sale qualifies as a qualifying disposition or a disqualifying disposition.

Qualifying vs. Disqualifying Disposition: The Holding Period Rules

A qualifying disposition produces long-term capital gain on the entire spread from exercise price to sale price, taxed at the preferential 0, 15, or 20 percent federal rates (plus 3.8 percent Net Investment Income Tax if applicable). To qualify, you must meet both of the following holding periods under IRC Section 422(a):

• Hold the shares for more than two years from the grant date, AND
• Hold the shares for more than one year from the exercise date.

Failing either test produces a disqualifying disposition. The consequence is that the spread at exercise (FMV on exercise date minus exercise price) is recharacterized as ordinary income in the year of sale, taxed at the same rates as wages. Any additional gain above the exercise-date FMV is capital gain, long-term if held more than one year from exercise, short-term if not. The employer is supposed to report the ordinary income portion on your W-2 for a disqualifying disposition, though some employers miss this and require you to self-report.

The practical stakes: a qualifying disposition on $500,000 of ISO gain is taxed at 23.8 percent federal (20 percent plus NIIT) plus California ordinary rates (California does not recognize ISO preference treatment for state tax, so the full gain is taxed as California ordinary income regardless of federal treatment). A disqualifying disposition on the same $500,000 can face 37 percent federal plus 13.3 percent California on the ordinary portion. The difference runs $50,000 to $75,000 on this example.

83(b) Election for Early-Exercise ISOs

Many early-stage tech company stock option plans allow employees to exercise ISOs before they vest, a practice known as early exercise. The shares received are still subject to the company's repurchase right (the vesting schedule) until vesting occurs. Without an 83(b) election, each vest date would be the taxable event, and you would recognize ordinary income (for NQSOs) or an AMT preference item (for ISOs) based on the FMV at each vest date.

The Section 83(b) election accelerates that recognition to the exercise date. You file the election within 30 days of exercise (this deadline is absolute, there are no extensions, and missing it has no cure). For an ISO exercised at or near the grant date when the spread is near zero, the election means you recognize a minimal AMT preference item now instead of recognizing a potentially large one at future vest dates when the stock has hopefully appreciated.

If the stock is worth $1.00 per share and you exercise 100,000 options at a $0.50 strike price, the 83(b) election creates a $50,000 AMT preference item today. If you had waited until vest at $10.00 per share, the AMT preference item would be $950,000. The 83(b) election does not eliminate the AMT item; it minimizes it by locking in the low-FMV exercise date. This is one of the most powerful planning moves available to early employees at startups, and one of the most missed. See our companion post on the Section 83(b) election for the mechanics and filing instructions.

AMT on ISO Exercise: What Actually Happens

The Alternative Minimum Tax operates as a parallel tax system. Every year you calculate your regular income tax and your AMT. You pay whichever is higher. The AMT exemption for 2026 is $137,000 for single filers and $220,700 for married filing jointly, phasing out at higher AMTI levels. The AMT rate on most ISO spread income is 28 percent above the exemption.

For a married Bay Area engineer exercising ISOs with a $400,000 spread in a year with $300,000 in wages and a standard deduction, the rough AMT exposure might look like: AMTI of $700,000 minus the exemption (which has phased out significantly by this income level) times 28 percent. The calculation can easily generate an AMT liability of $80,000 to $150,000 that has no regular income tax equivalent at all, because regular income tax sees no income from the ISO exercise.

The critical planning point is timing. Exercising ISOs in stages across multiple years, rather than all at once, keeps each year's AMT preference item manageable. Modeling the AMT exposure before exercise, not after, is the professional standard. We run this calculation every time we advise on ISO exercise strategy.

RSU vs. ISO: Side-by-Side Comparison

OBBBA 2025 Considerations

The One Big Beautiful Bill Act (OBBBA, Public Law 119-21, signed July 4, 2025) made several changes relevant to equity compensation tax planning.

AMT exemption amounts: OBBBA made permanent the higher AMT exemptions enacted under TCJA (previously scheduled to sunset after 2025). The 2026 exemptions of $137,000 for single filers and $220,700 for married filing jointly are indexed to inflation and remain in place. For ISO holders, this is meaningful because higher exemptions reduce the AMT exposure on a given year's exercise spread, particularly for employees with moderate exercise amounts.

Capital gains rates: the 0, 15, and 20 percent brackets for long-term capital gains remain unchanged under OBBBA. The income thresholds that determine which bracket applies received inflation adjustments for 2026. For most senior Bay Area tech employees, gains from qualifying ISO dispositions and RSU post-vest appreciation will face the 20 percent rate plus 3.8 percent NIIT at the federal level.

QSBS interaction: OBBBA preserved Section 1202 QSBS exclusion treatment. Employees at early-stage C-corporations who receive ISOs and early-exercise them may have overlapping QSBS eligibility on those shares if the company meets the qualified small business stock requirements at the time of acquisition. This is a distinct analysis from the ISO holding period rules, and the two can layer together favorably. See our QSBS planning guide for the Section 1202 requirements and exclusion mechanics.

No change to ISO statutory framework: OBBBA did not amend IRC Section 422. The grant-exercise-disposition structure, the two-year and one-year holding period tests, and the AMT preference treatment of the exercise spread are all unchanged.

California Sourcing on Multi-State Vesting Moves

California's Franchise Tax Board takes an aggressive position on equity compensation income for employees who vest in California even if they no longer live here. The California Nonresident and Part-Year Resident source-income rules require apportioning equity compensation to California based on the ratio of California workdays to total workdays during the vesting period. This applies to both RSUs and ISOs.

For RSUs, the FTB sources the vest-date income based on your California workdays during the period from grant to vest divided by total workdays in that same period. If you were granted RSUs while living in California, moved to Texas in year two, and the RSUs vest in year three while you are a Texas resident, California will assert a right to tax the California-sourced portion of that RSU income. You must file a California nonresident return and pay California tax on that portion.

For ISOs, the analysis is similar but more nuanced because there are two relevant events: exercise and sale. California does not conform to the federal ISO ordinary-income deferral; it taxes the spread at exercise as California-source income if the options were granted and exercised in a California service period. In a qualifying disposition, California taxes the entire gain as ordinary income in the year of sale rather than as long-term capital gain, and the FTB's sourcing rules determine what fraction of that income belongs to California. For a disqualifying disposition, the ordinary income element recognized at sale is sourced similarly to RSUs.

The practical implication for Bay Area employees who relocate: leaving California does not eliminate California's claim on equity that vested or was granted during California employment. You need to track your workday allocation carefully across the vesting period, file California nonresident returns for the years in question, and avoid underreporting the California-source component. The FTB receives W-2 data and cross-references it against California workday records. See our full analysis at California RSU Tax Planning.

Decision Framework: RSUs or ISOs for Your Situation

The choice between RSUs and ISOs is usually made by the company, not the employee, but understanding which type you hold and its implications is essential for planning. When you do have input, typically at an early-stage company offering a choice, consider the following:

Choose or prefer ISOs when:

• The company is early-stage and the stock is low-valued today relative to your expected exit price, meaning the 83(b) election cost is minimal and the qualifying disposition upside is large.
• You have AMT capacity: your regular tax liability is already high enough that modest additional AMTI from ISO exercise does not cross the AMT threshold, or you can time exercises to stay under.
• You intend to hold long-term and can satisfy the two-year grant and one-year exercise holding periods without a forced sale.
• You want to preserve QSBS eligibility, which requires holding qualifying stock for at least five years and is easier to track starting from the early-exercise date.

Choose or prefer RSUs when:

• The company is public or late-stage and stock value is already substantial, meaning ISOs would create enormous AMT preference items at exercise with limited upside over RSUs in a qualifying disposition.
• You need immediate liquidity and plan to sell at vest or exercise, which would trigger a disqualifying disposition on ISOs and eliminate the capital gains preference.
• You want predictable withholding and do not want to manage estimated tax payments around AMT.
• California tax rate parity matters: for California purposes, ISO gains in a qualifying disposition still face ordinary rates, and RSU gains face ordinary rates at vest. The California analysis often makes ISOs less advantageous than the federal analysis alone would suggest.

FAQ

Why do I owe so much at tax time when my company already withheld on my RSUs?

Your company withholds at the IRS flat supplemental rate, which is 22 percent federal for the first $1 million in supplemental wages and 37 percent above that. If your combined federal and California marginal rate on RSU income is closer to 50 percent, the withholding is covering only 35 to 36 percent (22 percent federal plus roughly 13 percent California). The gap is 14 to 15 percentage points of your vest income, which you owe at filing. For a $300,000 vest year, that gap can be $40,000 to $50,000 owed plus potential underpayment penalties. The fix is quarterly estimated tax payments that cover the shortfall as shares vest throughout the year.

Does California give me the same capital gains preference on ISOs as the federal government?

No. California does not conform to federal ISO treatment. At the federal level, a qualifying ISO disposition produces long-term capital gain on the entire spread. California taxes the spread at exercise as ordinary income and applies ordinary income rates to the gain at sale. This means an ISO that qualifies for federal long-term capital gain treatment still faces California ordinary income rates of up to 13.3 percent on the full gain. For high earners in California, the state-level cost erodes a meaningful portion of the federal ISO preference.

I exercised ISOs this year and did not sell. Do I owe any tax?

Possibly. The spread between the exercise price and the fair market value on your exercise date is an AMT preference item. You add it to your alternative minimum tax income (AMTI) and calculate your AMT. If your AMT exceeds your regular income tax, you pay the AMT. Many employees are surprised to owe AMT in a year when they received no cash from the ISOs because they did not sell. The AMT credit generated in that year can be used to offset future regular tax in years when you sell the shares and recognize income, but the timing mismatch between the cash-out and the tax bill is the core ISO exercise risk. Always run the AMT projection before exercising.

What happens if I leave my company before my ISOs vest?

Unvested ISOs are typically forfeited when you leave. For vested ISOs, most plans give you 90 days from your termination date to exercise, after which unexercised options expire worthless. Options exercised after the 90-day window lose ISO status and are treated as nonqualified stock options (NQSOs) for tax purposes, meaning the spread at exercise becomes ordinary income subject to withholding. If you are leaving a company with significant vested ISO value, the 90-day exercise window is one of the most important deadlines in tax planning.

How does the 83(b) election work for ISOs, and when must I file it?

If your company allows early exercise (exercising before vesting), you can file an 83(b) election within 30 days of the exercise date to lock in the taxable spread at the low current price rather than recognizing it as shares vest in the future. For ISOs, the 83(b) election means the AMT preference item is calculated at the time of exercise when the spread is low (often near zero at an early-stage company). Missing the 30-day deadline forfeits the election permanently. You file the election with the IRS, attach a copy to your tax return for that year, and retain a copy in your records. The clock starts on the date of exercise, not the date you receive the shares or any other date.

I moved from California to another state mid-year. Do I still owe California tax on RSUs that vest after I leave?

Likely yes, in part. California sources RSU income to the state based on your California workdays during the vesting period, not solely based on where you live when the shares vest. If an RSU was granted while you worked in California and vests after you move, California claims the fraction of the vest income attributable to California service time. You would file a California nonresident return and pay California tax on that portion. The FTB is active in identifying nonresidents with California-source equity income, and failure to file is a known audit risk. Tracking your workday split across the vesting period and computing the California-source fraction correctly is essential after a mid-vesting relocation.

When to Talk to Us

RSU and ISO planning is not a filing exercise. It is a year-round tax management function for any Bay Area tech employee with meaningful equity. The withholding gap on RSUs costs real money if ignored. An unplanned ISO exercise in a high-spread year can produce a five or six-figure AMT bill that arrives the following April with no warning. The California sourcing rules on multi-state moves generate nonresident filing obligations that most employees do not know they have.

At Silicon Valley Tax, our team works specifically with Bay Area technology employees across the compensation spectrum, from mid-level engineers with standard FAANG RSU packages to startup employees with early-exercise ISO portfolios and complex QSBS eligibility questions. We model AMT exposure before each ISO exercise, build estimated tax payment schedules around your vesting calendar, and track California apportionment for clients who have relocated or are planning to. Our broader equity compensation tax service covers the full lifecycle from grant through disposition.

If you have ISOs you have not yet exercised, RSUs with a withholding shortfall, or a complex mix of both across multiple employers, the right time to model the tax impact is before the triggering event, not at filing. Schedule Now