Nothing at grant, tax at exercise
An NSO gives you the right to buy stock at a fixed strike price. There is no tax when it is granted or as it vests. The taxable event is exercise: when you buy the shares, the difference between their fair market value and your strike — the bargain element — is ordinary income, added to your W-2 and subject to income tax plus Social Security and Medicare.
The 22% withholding gap
Employers usually withhold at the 22% supplemental rate on the bargain element. If your marginal rate is higher, that is not enough and you owe the difference at filing. On a large exercise the shortfall can be substantial, so plan for it with an estimated payment in the quarter you exercise.
Your cost basis is the FMV, not the strike
Because you already paid income tax on the spread, your cost basis is the fair market value at exercise — not the strike price. Brokers often report only the strike on the 1099-B, which would tax the spread twice. Correct it on Form 8949 so only the gain since exercise is taxed as a capital gain.
Short-term vs long-term after exercise
Once you hold the shares, the capital-gains clock starts on the exercise date. Sell within a year and gains above the exercise-date value are short-term at your ordinary rate; hold more than a year for long-term 0/15/20% rates. The ordinary-income portion is already settled at exercise, so only the later appreciation is affected by the holding period.
NSO vs ISO
NSOs are simpler than incentive stock options: ordinary income at exercise with withholding, then normal capital gains, and no Alternative Minimum Tax. ISOs can defer regular tax and qualify for long-term rates on the whole gain, but carry AMT risk. Many people hold both; the right strategy differs for each.
A quick example
You exercise 1,000 NSOs at a $2 strike when the FMV is $12. The bargain element is $10,000 of ordinary income. At a 32% rate your employer withholds only 22% ($2,200) but you owe about $3,200 federally — a ~$1,000 gap before FICA. Your basis is $12/share. Sell a year later at $20 and the gain is ($20 − $12) × 1,000 = $8,000. If the broker reported a $2 basis, you would be taxed on $18,000 — paying tax again on the $10,000 already reported at exercise.