Ordinary Income
Income taxed at regular federal and state income tax rates, including wages, salaries, and — in the context of stock options — the spread on non-qualified stock options at exercise and disqualifying dispositions of incentive stock options.
What Is Ordinary Income?
Ordinary income is any income that is taxed at regular (non-preferential) income tax rates. This includes wages, salaries, bonuses, and — crucially for startup employees — certain stock option gains. When you exercise non-qualified stock options (NSOs) or make a disqualifying disposition of incentive stock options (ISOs), the IRS treats the spread (the difference between the fair market value and your exercise price) as ordinary income. This means it is taxed at the same rates as your salary, subject to the same federal brackets, state income tax, and payroll taxes.
Understanding when stock option gains are classified as ordinary income versus long-term capital gains is one of the most important aspects of equity compensation tax planning, because the difference in tax rates can be substantial.
How Ordinary Income Works with Stock Options
NSO Exercise
When you exercise non-qualified stock options, the spread at exercise is immediately treated as ordinary income. Your employer is required to report this income on your W-2 and withhold federal income tax, state income tax, Social Security tax (up to the annual wage base), and Medicare tax. The total tax burden on this ordinary income can reach 40–50% or more depending on your federal bracket and state of residence.
For example, if you exercise 10,000 NSOs with a $1 strike price when the FMV is $11, the spread is $10 per share, creating $100,000 of ordinary income. This is added to your other compensation for the year and taxed at your marginal rate.
ISO Disqualifying Disposition
If you exercise ISOs and sell the shares before meeting the ISO holding period requirements (at least two years from the grant date and one year from the exercise date), the spread at exercise is reclassified as ordinary income. This is called a disqualifying disposition. The tax treatment becomes essentially the same as NSOs — the spread is ordinary income, and any additional gain above the FMV at exercise is taxed as a capital gain.
Federal Tax Rates
For 2026, the federal ordinary income tax brackets are 10%, 12%, 22%, 24%, 32%, 35%, and 37%. A large stock option exercise can push your income into a higher bracket for that year. By contrast, long-term capital gains are taxed at 0%, 15%, or 20% — a significant difference that highlights the value of achieving ISO qualifying dispositions or holding shares long enough for long-term capital gains treatment.
Payroll Taxes
Ordinary income from NSO exercises is also subject to payroll taxes: 6.2% Social Security tax (employee portion, up to the annual wage base of approximately $176,100 in 2026) and 1.45% Medicare tax (no cap, plus an additional 0.9% above $200,000 for single filers). These taxes add to the total burden beyond just income tax rates.
Practical Implications for Startup Employees
The Ordinary Income Tax Hit Can Be Substantial
If you have a large NSO grant at a company with a high 409A valuation, exercising can create hundreds of thousands of dollars in ordinary income in a single year. This pushes you into the highest federal bracket and triggers significant state taxes. In a state like California (13.3% top rate), your combined marginal rate on NSO exercise income can exceed 50%.
Timing Exercises to Manage Brackets
Since ordinary income stacks on top of your salary and other income, the timing of your exercise affects which tax brackets you hit. Spreading exercises across multiple calendar years can keep more of the income in lower brackets. For example, exercising half your NSOs in December and half in January splits the income across two tax years.
The Ordinary Income vs. Capital Gains Gap
The difference between ordinary income tax rates and long-term capital gains rates can be 20+ percentage points. This gap is what makes ISO planning and holding period management so valuable. If you can achieve a qualifying disposition on ISOs, the spread that would have been ordinary income (in a disqualifying disposition) is instead taxed at the lower capital gains rate.
State Taxes Compound the Impact
States with high income tax rates (California at 13.3%, New York at 10.9%, plus NYC at 3.876%) add a significant layer on top of federal ordinary income taxes. Some states, like Texas and Washington, have no income tax on wages (though Washington has a 7% capital gains excise tax). Your state of residence when you exercise materially affects your total tax bill on ordinary income.
How It Relates to Exercising Stock Options
Whether your exercise generates ordinary income or capital gains income depends on the type of option (ISO vs. NSO), the holding period, and the disposition type. For NSOs, the ordinary income treatment at exercise is unavoidable — your planning focus is on timing and bracket management. For ISOs, the goal is to avoid triggering ordinary income by meeting the qualifying disposition requirements. In either case, calculate your expected ordinary income from an exercise and model the total tax bill — including federal, state, and payroll taxes — before committing to exercise.