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The Employee’s Guide to IPO Tax Planning: How to Manage Your ‘Enormous Income Year’

The tax implications of an initial public offering will depend on the type of equity you hold.

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Taryn Phaneuf

Lead Writer & Content Strategist

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14 years of experience

Expertise

• Financial advisors
• employee equity
• 529 plans

Taryn Phaneuf is a lead writer & content strategist covering wealth management, financial planning and other investing topics at NerdWallet. She previously reported on personal finance news. Prior to joining NerdWallet, she spent more than a decade covering education, public policy and business for various news outlets. She also taught journalism as an adjunct instructor at her alma mater, the University of Minnesota.

She lives in Minnesota.

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Lead Writer & Content Strategist

Taryn Phaneuf is a lead writer & content strategist covering wealth management, financial planning and other investing topics at NerdWallet. She previously reported on personal finance news. Prior to joining NerdWallet, she spent more than a decade covering education, public policy and business for various news outlets. She also taught journalism as an adjunct instructor at her alma mater, the University of Minnesota.

She lives in Minnesota.

Mary M. Flory

Senior Editor & Content Strategist

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10 years of experience

Mary Flory leads NerdWallet's growing team of assigning editors at large. Before joining NerdWallet's content team, she had spent more than 12 years developing content strategies, managing newsrooms and mentoring writers and editors. Her previous experience includes being an executive editor at the American Marketing Association and an editor at news and feature syndicate Content That Works.

Senior Editor & Content Strategist

Mary Flory leads NerdWallet's growing team of assigning editors at large. Before joining NerdWallet's content team, she had spent more than 12 years developing content strategies, managing newsrooms and mentoring writers and editors. Her previous experience includes being an executive editor at the American Marketing Association and an editor at news and feature syndicate Content That Works.

Three types of equity are commonly held by employees at pre-IPO companies: restricted stock units (RSUs), incentive stock options (ISOs) and non-qualified stock options (NSOs). Each has its own tax rules and strategies. When you hold more than one type, or even all three — which is true of many employees at companies like Anthropic and SpaceX — the tax implications become even more complex.

Before the IPO, it’s smart to take stock of what you own and what the tax implications are. But good tax planning spans multiple tax years and accounts for a variety of scenarios. Consider working with a financial advisor or tax professional who can help you model potential outcomes and give you personalized advice. And keep in mind that “financial advisor” is not a regulated term — take time to verify the credentials of anyone you may work with.

What type of equity do you hold?

Read each of the sections below that correspond with the type of equity you own. If you hold more than one type, read the section on mixed equity to understand how they interact.

RSUs: Restricted stock units that vest at IPO.

ISOs: Incentive stock options with an exercise decision to make.

NSOs: Nonqualified stock options with straightforward tax implications.

All of the above: Tax strategies for when you have a mix of ISOs, NSOs and RSUs.

This article discusses federal taxes, but you may also need to consider state income taxes, which vary widely. California, for example, has no favorable capital gains rate at the state level, so all gains on RSUs or stock options are taxed as ordinary income.

A lockup agreement is a significant factor to plan around. Lockup agreements prevent company insiders, including employees, from selling stock for a set period of time after an IPO. They typically last six months, but the specific terms will vary by company. 

If you don’t know which types of equity you hold, you should be able to find that information on your company’s equity platform. Review our IPO financial planning guide for more tips on what to do to prepare for an IPO.

RSUs

Ordinary income at vesting

With RSUs, the main tax event occurs at vesting, which could be on IPO day. Some RSUs vest on a predetermined timeline, but others may be double-trigger RSUs, which vest only after another event takes place, such as an IPO. It’s possible for employees at pre-IPO companies to hold both, says Aaron Brickley, a certified financial planner and certified private wealth advisor with Brickley Wealth Management in San Mateo, California.

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The second trigger can be an advantage because it ensures you aren’t paying taxes on private company stock you can’t sell. But it means all your RSUs will vest at once, and the value of those shares is treated as income. “You may have an enormous income year in the year of an IPO,” Brickley says. “So what sort of planning do you maybe do for that?”

There are multiple steps you could take to reduce your tax liability or otherwise make the most of a high-income year, Brickley says. For example, you may ramp up retirement contributions, set up a donor-advised fund to get a charitable tax deduction or exercise additional stock options (more on this later). The right set of strategies during the year of the IPO also requires keeping in mind your broader financial plan.

» Estimate the value of your shares with our RSU calculator

Watch out for the withholding gap

Employers often withhold taxes on RSUs at the time they vest. You may be able to elect to “sell to cover,” which allows you to automatically sell a portion of your newly vested shares for tax withholding. But make sure you’re withholding enough to cover your tax liability, or plan to make estimated quarterly tax payments.

The IRS default tax withholding rate is 22%. (Though any supplemental income above $1 million is withheld at 37%.) If your tax bracket is higher than 22%, the default rate won’t withhold enough to cover what you actually owe. To avoid a surprise tax bill, calculate what you’ll owe in taxes during the year your RSUs vest. If the withholding rate is too low, you’ll need to make changes before the RSUs vest. Your company’s HR department or equity platform can walk you through those steps.

Beware of overcorrecting, though, Brickley says. If you overwithhold on RSUs, it could mean you sold more shares than necessary to cover taxes, missing out on further gains you would have realized if you’d held the shares. The right withholding rate will depend on your full financial picture. You’ll need to take into account any additional income and deductions, as well as state taxes.

After vesting: Capital gains tax on growth

You may owe capital gains tax on any shares that appreciate before you sell them. The tax rate will depend on how long you held the stock.

Less than a year after vesting: Any gain is treated as a short-term capital gain and taxed at your ordinary income rate.

More than a year after vesting: Any gain is treated as a long-term capital gain and taxed at 0%, 15% or 20%, depending on your income.

RSU tax events

Tax event

What's taxed

Tax rate

Vesting at IPO

Value of the vested shares

Ordinary income (up to 37%)

Selling after lockup (held less than 1 year)

Gain since vesting

Short-term capital gains are taxed at your ordinary income tax rate.

Selling after lockup (held more than 1 year)

Gain since vesting

Long-term capital gains (0%, 15% or 20%)

ISOs

Ordinary income tax deferred at exercise

ISOs don’t typically trigger a taxable event until you sell them. That means they aren’t taxed at the time they’re granted, upon vesting or when exercised. If you exercise your ISOs before or after the IPO, the difference between the fair market value (FMV) and your strike price (called the “bargain element” or “spread”) won’t count as income on your federal taxes.

However, you may owe alternative minimum tax (AMT). More on that below.

When you choose to sell your shares, ISOs may be subject to the lower long-term capital gains tax rate (instead of your ordinary income tax rate) if you meet certain holding requirements. Two things must be true:

You held shares for at least a year from the exercise date.

You held your shares for at least two years from the grant date. 

If you don’t meet the holding requirement, the bargain element is taxed as ordinary income, and you may owe capital gains tax on any appreciation.

» Learn strategies for reducing capital gains tax

Watch out for the AMT trap

Alternative minimum tax, AMT, is a parallel tax system designed to ensure high-earning households pay a minimum amount in federal income taxes. For that reason, it doesn’t extend the same tax breaks that the ordinary income tax system does. For one, there’s no state and local tax deduction. And ISOs don’t get favorable treatment. Instead, when you exercise ISOs, the bargain element is counted as income.

At tax time, you calculate your tax liability under each of the systems, and you pay whichever is highest. What’s tricky about this is you haven’t yet sold your shares. So you may owe taxes on income you haven’t fully realized yet. If you exercise options and pay AMT, and then the price of your shares goes down before you sell, you may have overpaid taxes.

There are strategies to use if you want to avoid AMT. For example, you may decide to limit the number of ISOs you exercise so that AMT doesn’t exceed your ordinary income tax liability, says Steve Moyer, a certified financial planner and certified equity professional with Mariner, a wealth management firm. "What I always talk to people about is at least exercising up to the equilibrium point — the point where regular tax equals AMT,” he says. “We don't always want to go into AMT, but we want to push at least up to that point every single year."

It’s not always possible to avoid AMT, though. The key is to avoid being surprised by it. If you know you may owe AMT, you’ll need to plan for the tax bill. "That's actually a good thing because it means the options have grown quite significantly," Moyer says.

ISO tax events

Tax event

What's taxed

Tax rate

Exercise ISOs

Bargain element added to AMT but not to ordinary income.

AMT rate (26% or 28%)

Sale — one or both holding periods not met (called a “disqualifying disposition”)

Bargain element at exercise; capital gains since exercise

Ordinary income (up to 37%)

Sale — both holding periods met (called a “qualifying disposition”)

Full gain from strike price

Long-term capital gains (0%, 15% or 20%)

NSOs

NSOs are stock options that don’t get the same favorable tax treatment of ISOs. It’s common for startup employees to accumulate both types of options if they’ve been at a growing, pre-IPO company for a few years. Here’s why:

The $100K rule: Your ISO grant likely includes a vesting period. Once it’s complete (all at once or in stages), your ISOs become exercisable. The IRS says only $100,000 in ISOs can become exercisable by any individual in a single calendar year. Anything above that is treated as an NSO. At a high-growth company, if values and grant sizes increase, more of each grant may exceed the $100K threshold.

Company maturity: A company may shift to NSOs intentionally, as well, Moyer says. One reason might be to get a corporate tax deduction that companies get when employees report income from exercised NSOs.

What to know about NSO taxes

NSOs are taxable when you exercise. At that time, the bargain element (FMV minus your strike price) is treated as ordinary income. When you sell, you may owe short- or long-term capital gains on any appreciation above the FMV on the date you exercised.

NSO tax events

Tax event

What's taxed

Tax rate

Exercise NSOs

Bargain element (FMV minus strike price)

Ordinary income (up to 37%)

Selling within a year of exercise

Gain since exercise

Short-term capital gains are taxed at your ordinary income tax rate.

Selling after a year from exercise

Gain since exercise

Long-term capital gains (0%, 15% or 20%)

Mixing equity changes the math

ISOs, NSOs and RSUs may have differing mechanics but they all show up on the same tax return. The interaction creates at least two surprising possibilities.

1. High ordinary income gives you a bigger AMT cushion

During an IPO, double-trigger RSUs may vest and are treated as ordinary income. Similarly, any NSOs you exercise also get tallied in your W-2. “We saw this with SpaceX,” says Moyer, whose clients include employees at the company. “A lot of people had larger grants and the price went up quite significantly. So they might have several million dollars of RSU income this year.”

That can be a reason to exercise even more shares — as long as they’re ISOs. That’s because the difference in the highest tax rates between the ordinary income tax system and AMT naturally leaves room to exercise ISOs without triggering AMT. Moyer calls it the AMT cushion. The higher your ordinary income is in a given tax year, the larger your AMT cushion is, and the more ISOs you can exercise and hold — starting the clock on the one-year holding period required to get favorable tax treatment — without owing AMT.

» Learn more: Why you may want a financial team for an IPO

2. A guaranteed AMT bill lowers your ordinary income tax rate

Alternatively, if you exercise so many ISOs that you’ve essentially guaranteed you’ll have an AMT bill, any ordinary income you earn that year — from NSOs, RSUs or other sources — is taxed at the AMT rate. The highest is 28%, compared to 37% in the ordinary tax system.

In that case, it can be strategic to maximize your ordinary income, knowing you’ll pay a lower tax rate. For example, someone who holds NSOs might exercise and sell those, so they can hold their exercised ISOs until they’ve met holding requirements, Moyer says. “They can exercise millions of dollars of NSO income and only be taxed at 28%."

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