By Joe Wallin | April 9, 2026 | ~9 min read
In This Guide
- → Understanding ISOs and NSOs: The Foundation
- → Washington's 2028 Income Tax: The New Reality
- → The ISO Advantage—And Its Limits
- → The AMT Trap: Don't Overlook Federal Planning
- → Early Exercise and Section 83(b) Elections: The Accelerated Path
- → Liquidity Constraints and The Real-World Problem
- → The QSBS and Section 1202 Connection
- → NSO Exercise Timing: The Straightforward Calculation
- → The 2027 Planning Window
- → The Interaction with QSBS and Entity-Level Planning
- → Your Pre-Year-End Checklist
- → A Final Word on Interaction with Other Tax Planning
- → The Bottom Line
If you hold stock options in a Washington-based startup or have options in any company where you're a Washington resident, you're about to face a decision that could save you tens or hundreds of thousands of dollars in taxes. Washington's new income tax—effective January 1, 2028—changes the math on when you should exercise your options. And unlike most tax deadlines that sneak up on people, this one has a clear runway: 2027 is the last full year you can exercise options and avoid the 9.9% state income tax on the gains.
This post will walk you through the mechanics of stock option exercise, explain how Washington's new tax regime impacts your planning, and give you a practical framework for deciding what to do before the clock strikes midnight on December 31, 2027.
This post is part of our Complete Guide to Washington's New Income Tax.
Understanding ISOs and NSOs: The Foundation
To plan effectively around Washington's income tax, you need to understand the two types of stock options and how they're taxed at exercise. They have fundamentally different tax consequences, and the distinction only gets more important under the new tax regime.
Incentive Stock Options (ISOs) are the tax-favored option type. When you exercise an ISO, you recognize no ordinary income at the time of exercise. Instead, you owe only Alternative Minimum Tax (AMT) preference, and only if your total preference items push you into AMT that year. This is powerful: if you exercise an ISO with a $10 spread on 10,000 shares, you don't owe $100,000 in federal income tax at exercise. You might owe nothing in regular tax, though the $100,000 is an AMT preference item that could trigger federal AMT if you're close to the AMT threshold.
Non-Qualified Stock Options (NSOs) work differently. When you exercise an NSO, you recognize ordinary income equal to the spread at exercise—the fair market value of the stock minus your exercise price. If you exercise an NSO with a $10 spread on 10,000 shares, you recognize $100,000 in ordinary income immediately. That income is subject to federal income tax, state income tax (including Washington's new income tax if you're exercising in 2028 or later), and self-employment taxes if you're self-employed.
This distinction is about to matter more than it ever has for Washington residents.
Washington's 2028 Income Tax: The New Reality
In November 2021, Washington voters approved a capital gains tax. But that was narrowly crafted and did not generate enough revenue for the legislature's ambitions. So in 2024, the state passed a new income tax—a 9.9% tax on adjusted gross income above $1 million, effective January 1, 2028. This is ESSB 6346, and it's a genuine tax on income, not just capital gains.
For startup employees and founders in Washington, this creates a timing problem. If you exercise NSOs in 2027, that ordinary income is not subject to Washington income tax. If you wait until 2028, it is. For someone with a large NSO spread, the difference between exercising in 2027 versus 2028 is the difference between owing 0% state tax and owing 9.9% state tax on that income.
Consider a concrete example: you have 10,000 NSOs with an exercise price of $1 per share. The current fair market value is $11 per share, giving you a $10 per share spread, or $100,000 of income at exercise. If you exercise in December 2027, you owe federal income tax (let's say 37% plus 3.8% net investment income tax = 40.8%) and self-employment taxes if applicable. You owe zero Washington income tax. Total: roughly $40,800. If you wait until January 2028 and exercise the same options, you owe the same federal tax plus 9.9% Washington income tax, which is an additional $9,900. That's a 24% difference in after-tax proceeds.
For someone exercising options in the six or seven figure range, 2027 versus 2028 exercise could mean a difference of $50,000, $100,000, or more in after-tax cash.
The ISO Advantage—And Its Limits
ISOs look more attractive in light of Washington's new tax. At exercise, you recognize no ordinary income, so you avoid both federal and Washington income tax at the moment you hit the button. The spread is untaxed, and only the AMT preference item matters for federal purposes.
But this advantage has a critical limit: when you sell the stock. If you exercise an ISO and then sell the shares within two years of the grant date or one year of the exercise date—a "disqualifying disposition"—the spread becomes ordinary income subject to both federal and Washington tax. And if you exercise in 2027 but don't sell until 2028 or later, you've deferred ordinary income recognition, but the ordinary income you recognize on the disqualifying disposition in 2028 will be subject to Washington's new income tax.
That said, ISOs do provide planning opportunities. If you exercise an ISO in 2027 and then hold the shares through the end of 2027, you've locked in the ISO treatment: any gain above the fair market value at exercise—gains accrued after 2027—will be capital gains, not ordinary income. For QSBS treatment, this is significant.
The AMT Trap: Don't Overlook Federal Planning
Here's where ISO planning gets complicated. If you exercise a large block of ISOs in 2027 to avoid Washington income tax, you could trigger federal AMT, which would actually result in paying federal tax at exercise—potentially more tax than you would have paid by spreading exercises over multiple years or using NSOs instead.
The AMT tax rate is 26% up to $215,000 of income (in 2026) and 28% above that. If your regular tax is lower—say, you have large charitable deductions or capital losses—you might be in AMT territory. The AMT preference for exercising ISOs is 100% of the spread, which means a $500,000 spread on ISOs could generate a $500,000 AMT preference item. At 28% AMT, that's $140,000 in federal tax—more than you'd pay on NSOs under many circumstances.
The lesson: don't assume ISO exercise is always cheaper. Run the numbers with your tax advisor, and consider spreading large ISO exercises across multiple years or fiscal quarters if necessary to stay out of AMT.
Early Exercise and Section 83(b) Elections: The Accelerated Path
If you have unvested options, you have another tool: early exercise with a Section 83(b) election. This is where you exercise your options before they vest, and then you file a Section 83(b) election with the IRS within 30 days to lock in the income recognition at the time of exercise rather than at the time of vesting.
The tax consequence is that you recognize ordinary income at the time of exercise (for NSOs) or only an AMT preference (for ISOs) even though the shares aren't vested yet. But here's the planning angle: if you exercise unvested options in 2027 when the value is low, you lock in low income recognition in a year with no Washington income tax. By the time the shares vest in 2028, the tax event has already occurred—you don't owe additional tax when vesting happens.
For someone expecting substantial appreciation, this can be enormously valuable. If your startup is growing quickly and options granted today at a $2 fair market value might be worth $10 at the time of vesting in 2029, early exercise in 2027 locks in the $2 value as your income basis, while all the growth from $2 to $10 (and beyond) is treated as capital gains, not ordinary income.
The catch: you need the cash to exercise, and you need to believe in the company's long-term value. Early exercise is a bet on the business.
Liquidity Constraints and The Real-World Problem
The biggest issue with exercising options before 2028—whether ISOs or NSOs—is cash. Most employees can't simply write a check for hundreds of thousands of dollars to exercise options. You need either liquid assets, a loan against future stock, or a way to exercise and sell simultaneously.
Some of these approaches are available. If your company permits cashless exercise or broker-assisted exercise, you can exercise and immediately sell some shares to cover the exercise price and taxes, pocketing the rest. If the company offers an option to borrow against your vested shares to exercise more, that can help. Some startups offer short-term loans to employees specifically to fund option exercises before key tax deadlines.
But many startup employees face a harsh reality: their options are underwater (the current fair market value is below the exercise price) or the company has transfer restrictions that prevent selling shares. In either case, exercising before 2028 may not be possible, and you'll have to plan around that constraint.
The QSBS and Section 1202 Connection
If your stock qualifies for treatment under Section 1202 of the Internal Revenue Code—the QSBS exclusion—the timing of your option exercise becomes even more important. Section 1202 allows you to exclude up to $10 million of gain (or 10 times your basis, whichever is higher) on the sale of qualified small business stock held for at least five years. The recent OBBBA changes increased the gain exclusion to $15 million and raised the gross asset limits to $75 million.
The clock on the five-year holding period starts when you exercise the option. If you exercise in 2027, your five-year holding period expires in 2032. If you exercise in 2028, it expires in 2033. The earlier you exercise, the earlier you can get the Section 1202 exclusion.
More importantly, if you exercise in 2027 at a lower value (especially true for early exercise) and the stock appreciates substantially before you sell, the spread between your basis and the sale price is eligible for the Section 1202 exclusion. That's potentially massive tax savings—millions of dollars in a liquidity event.
NSO Exercise Timing: The Straightforward Calculation
If you hold NSOs, the decision is more straightforward than with ISOs. Every dollar of ordinary income you recognize at exercise in 2027 avoids Washington income tax. Every dollar you recognize in 2028 or later is subject to Washington income tax if your adjusted gross income exceeds $1 million and you're a Washington resident.
For someone above that threshold—and many startup employees and founders with valuable options will be—the choice is clear: exercise NSOs before the end of 2027 if you can. The 9.9% savings is real money.
The only complicating factors are AMT (less of an issue with NSOs than with ISOs, but still possible if you exercise a very large amount), alternative minimum tax credit carryforwards (which can offset future AMT), and whether you expect your income to be above or below the $1 million threshold in the exercise year and the disposition year.
The 2027 Planning Window
We are now in early 2026. That means there are roughly 20 months until the end of 2027—roughly 20 months to complete your option exercise planning. This is not infinite runway, but it's enough time if you move deliberately.
Here's what that window demands: meet with your tax advisor and your company's legal team now. Understand your option grants, the current fair market value, your future compensation, and your likely tax bracket. Model out the federal, state, and self-employment tax consequences of exercising different blocks of options in different years. Understand any transfer restrictions, blackout periods, or company policies that might prevent you from exercising.
If you need loans to exercise, apply for them now so the company can process them. If you're considering early exercise, start that conversation with your company. If you want to do a coordinated exercise and sale, begin discussing that structure with your broker or company.
Don't wait until November 2027 to start thinking about this. The most tax-efficient structures take time to implement.
The Interaction with QSBS and Entity-Level Planning
The value of QSBS amplifies the importance of exercise timing. Check our guide to QSBS to understand whether your stock qualifies. If it does, exercising options in 2027 at a favorable basis, then holding for five years, gives you exposure to the Section 1202 exclusion on all appreciation above your exercise price basis. That's not available if you delay exercise until after the clock starts in 2028 or beyond.
Similarly, if you're a founder considering entity structure or conversion, the interaction with Washington's income tax matters. Read our guide to entity choice under Washington income tax to understand whether your entity structure affects your option planning.
Your Pre-Year-End Checklist
Before the end of 2027, you should have completed the following planning steps. First, understand the spread on each grant of options you hold—the difference between the exercise price and the current fair market value. Second, calculate the ordinary income at exercise, the federal income tax, the Washington income tax (if applicable), and any AMT consequences. Third, determine your after-exercise liquidity: can you afford to exercise, or do you need a company loan or cashless exercise? Fourth, understand any company transfer restrictions or holding periods that might limit when you can sell after exercise. Fifth, confirm whether the stock is QSBS and understand the five-year holding period requirements. Sixth, discuss with your tax advisor whether early exercise of unvested options makes sense for your situation. Seventh, coordinate the exercise with your company's legal and financial teams to ensure compliance with any grant agreements, plan provisions, or securities law requirements.
This is not a tax return checklist. This is a planning checklist to be completed well in advance of the year-end deadline.
A Final Word on Interaction with Other Tax Planning
Option exercise timing also interacts with other tax-planning strategies. For instance, if you're considering Roth conversions before 2028, exercising NSOs in the same year might push you over the $1 million threshold, subjecting both the option income and the conversion income to Washington tax. Conversely, exercising in 2027 gives you breathing room for other planning in 2028 and beyond. Similarly, if you're thinking about estate planning before Washington's income tax takes effect, the timing of your exercise affects your estate plan.
These interactions underscore a key principle: option exercise timing is not an isolated tax decision. It's part of a broader landscape that includes federal taxes, state taxes, estate planning, and business circumstances. The best outcome requires coordinating with your tax advisor and perhaps your legal counsel on all of these dimensions.
The Bottom Line
Washington's 2028 income tax has created a genuine planning opportunity for option holders. For NSO holders with ordinary income spreads, exercising in 2027 saves 9.9% in state tax versus exercising in 2028 or later. For ISO holders, the advantage is more subtle—avoiding state tax at exercise and potentially improving QSBS basis—but it's still real. For everyone with options, the 2027 calendar year is the last tax-free planning window. After December 31, 2027, any exercise income you recognize will be subject to Washington's new income tax if you're a resident with income above $1 million.
The best time to make this decision was months ago. The second-best time is now. Don't let the 2028 income tax surprise you.
If you're a startup founder, employee, or investor with options in a Washington-based company and you're unsure how to approach this planning, let's talk. Book a free introductory call and we can walk through your specific situation and options.
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