As with any type of investment, when you realize a gain, it's considered income. Income is taxed by the government. How much tax you'll ultimately wind up paying and when you'll pay these taxes will vary depending on the type of stock options you're offered and the rules associated with those options. There are two basic types of stock options, plus one under consideration in Congress. An incentive stock option (ISO) offers preferential tax treatment and must adhere to special conditions set forth by the Internal Revenue Service. This type of stock option allows employees to avoid paying taxes on the stock they own until the shares are sold. When the stock is ultimately sold, short- or long-term capital gains taxes are paid based on the gains earned (the difference between the selling price and the purchase price). This tax rate tends to be lower than traditional income tax rates. The long-term capital gains tax is 20 percent, and applies if the employee holds the shares for at least a year after exercise and two years after grant. The short-term capital gains tax is the same as the ordinary income tax rate, which ranges from 28 to 39.6 percent. Tax implications of three types of stock options ISO NQSO Super stock option Employee exercises options No tax Ordinary income tax (28% - 39.6%) No tax Employer gets tax deduction? No deduction Tax deduction upon employee exercise Tax deduction upon employee exercise Employee sells options after 1 year or more Long-term capital gains tax at 20% Long-term capital gains tax at 20% Long-term capital gains tax at 20% Source: Salary.com. Nonqualified stock options (NQSOs) don't receive preferential tax treatment. Thus, when an employee purchases stock (by exercising options), he or she will pay the regular income tax rate on the spread between what was paid for the stock and the market price at the time of exercise. Employers, however, benefit because they are able to claim a tax deduction when employees exercise their options. For this reason, employers often extend NQSOs to employees who are not executives. Taxes on 1,000 shares at an exercise price of $10 per share ISO NQSO Employee exercises when market value is $20 per share No tax paid Tax = ($20 - $10)*1,000*(0.28) = $2,800 Employee sells at $30 per share after holding one year or more ($30 - $10)*1,000*(0.20) = $4,000 ($30 - $20)*1,000*(0.20) = $2,000 Total tax paid $4,000 $4,800 Source: Salary.com. Assumes an ordinary income tax rate of 28 percent. The capital gains tax rate is 20 percent. In the example, two employees are vested in 1,000 shares with a strike price of $10 per share. One holds incentive stock options, while the other holds NQSOs. Both employees exercise their options at $20 per share, and hold the options for one year before selling at $30 per share. The employee with the ISOs pays no tax on exercise, but $4,000 in capital gains tax when the shares are sold. The employee with NQSOs pays regular income tax of $2,800 on exercising the options, and another $2,000 in capital gains tax when the shares are sold. Penalties for selling ISO shares within a year The intent behind ISOs is to reward employee ownership. For that reason, an ISO can become "disqualified" - that is, become a nonqualified stock option - if the employee sells the stock within one year of exercising the option. This means that the employee will pay ordinary income tax of 28 to 39.6 percent immediately, as opposed to paying a long-term capital gains tax of 20 percent when the shares are sold later. Other types of options and stock plans In addition to the options discussed above, some public companies offer Section 423 Employee Stock Purchase Plans (ESPPs). These programs permit employees to purchase company stock at a discounted price (up to 15 percent) and receive preferential tax treatment on the gains earned when the stock is later sold. Many companies also offer stock as part of a 401(k) retirement plan. These plans allow employees to set aside money for retirement and not be taxed on that income until after retirement. Some employers offer the added perk of matching the employee's contribution to a 401(k) with company stock. Meanwhile, company stock can also be purchased with the money invested by the employee in a 401(k) retirement program, allowing the employee to build an investment portfolio on an ongoing basis and at a steady rate. Special tax considerations for people with large gains The Alternative Minimum Tax (AMT) may apply in cases where an employee realizes especially large gains from incentive stock options. This is a complicated tax, so if you think it may apply to you, consult your personal financial advisor. More and more people are being affected. - Jason Rich, Salary.com contributor