Net Unrealized Appreciation Strategy

What Net Unrealized Appreciation Accomplishes

Net Unrealized Appreciation (NUA) is a tax provision that allows employees holding employer stock in a 401(k) to pay long-term capital gains rates (0%, 15%, or 20%) on the appreciation instead of ordinary income rates (up to 37%) that normally apply to 401(k) distributions.

For an employee with $500,000 of employer stock (cost basis $100,000, appreciation $400,000), the NUA strategy saves approximately $68,000 in federal taxes compared to rolling the stock into an IRA and selling.

The strategy applies exclusively to employer stock (company you work for) held in employer-sponsored retirement plans. It does not apply to mutual funds, ETFs, or stock of other companies.

Source: IRC Section 402(e)(4), IRS Publication 575.

How NUA Treatment Works

The mechanics differ fundamentally from standard 401(k) distribution rules:

Standard 401(k) distribution (without NUA):

1. Roll 401(k) to IRA
2. Sell stock in IRA
3. Withdraw cash from IRA
4. Pay ordinary income tax on entire amount (up to 37%)

NUA distribution:

1. Take lump-sum distribution of employer stock in-kind (receive actual shares)
2. Pay ordinary income tax only on your cost basis
3. Transfer shares to taxable brokerage account
4. Sell shares when desired
5. Pay long-term capital gains tax (15-20%) on the NUA portion
6. Any appreciation after distribution is short-term or long-term depending on holding period

The key distinction: NUA is taxed at capital gains rates even though the appreciation occurred inside a tax-deferred account.

Lump-Sum Distribution Requirements

NUA treatment requires a lump-sum distribution meeting specific criteria:

Requirement 1: Triggering event

Distribution must occur after one of four triggering events:

• Separation from service (any age)
• Reaching age 59.5
• Death
• Disability (self-employed only)

Requirement 2: Complete distribution

The entire account balance from ALL plans of the same type with that employer must be distributed within one calendar year. Partial distributions disqualify NUA treatment.

What this means: If you have a 401(k) and a separate profit-sharing plan with the same employer, both must be distributed in the same calendar year.

Requirement 3: In-kind distribution

The employer stock must be distributed as actual shares, not sold within the plan and distributed as cash. The shares move directly from your 401(k) to your taxable brokerage account.

NUA vs. Rollover: Side-by-Side Comparison

Worked Example: $600,000 of Employer Stock

Starting position:

• Employer stock fair market value: $600,000
• Your cost basis in the stock: $120,000
• Net Unrealized Appreciation: $480,000
• Federal tax bracket: 32%
• Long-term capital gains rate: 20%
• Age: 62 (separated from service)

Scenario A: Standard IRA Rollover (No NUA)

1. Roll $600,000 to Traditional IRA
2. Sell stock immediately inside IRA: No tax yet
3. Eventually withdraw $600,000 from IRA over retirement
4. Tax owed: $600,000 x 32% = $192,000 ordinary income tax

Scenario B: NUA Strategy

Step 1: Take lump-sum distribution of stock in-kind

• Receive 10,000 shares in taxable brokerage account
• Immediate tax on cost basis: $120,000 x 32% = $38,400

Step 2: Hold shares in taxable account (minimum 1 day for immediate sale)

Step 3: Sell shares at $600,000

• NUA taxed at long-term capital gains: $480,000 x 20% = $96,000

Total NUA taxes: $38,400 + $96,000 = $134,400

Comparison

The point: NUA converted $480,000 from 32% ordinary income tax to 20% long-term capital gains tax, saving 12 percentage points on the appreciation.

When NUA Provides Maximum Benefit

NUA savings increase under specific conditions:

High appreciation relative to basis

The larger the NUA compared to cost basis, the greater the benefit. A stock with $50,000 basis and $450,000 NUA (9:1 ratio) benefits more than one with $200,000 basis and $300,000 NUA (1.5:1 ratio).

High ordinary income tax bracket

NUA benefit equals: NUA x (Ordinary Rate - LTCG Rate)

At 37% ordinary / 20% LTCG: 17 percentage points saved At 24% ordinary / 15% LTCG: 9 percentage points saved At 12% ordinary / 0% LTCG: 12 percentage points saved

No need for immediate liquidity

If you need the cash immediately, NUA still works but triggers capital gains tax quickly. If you can hold the shares, additional appreciation receives favorable capital gains treatment and potentially a stepped-up basis at death.

Concentrated position is acceptable

NUA requires keeping employer stock (at least temporarily) rather than diversifying immediately inside the 401(k). If company risk concerns you, factor that into the decision.

Hybrid Strategy: Partial NUA Election

You can apply NUA treatment to only a portion of your employer stock while rolling the remainder to an IRA. This balances tax savings against diversification needs.

Example:

• Total employer stock: $600,000 (basis $120,000)
• Take NUA on $300,000 (basis $60,000, NUA $240,000)
• Roll $300,000 to IRA for diversification

Execution: Specify at distribution which specific lots of stock receive NUA treatment and which roll to IRA. The entire balance must still be distributed in the same calendar year.

Common Pitfalls

Pitfall 1: Incomplete distribution

Leaving any balance in any plan of the same type with the same employer disqualifies the entire NUA election. All balances across 401(k), profit-sharing, and stock purchase plans with that employer must be distributed in the same calendar year.

Example of failure: You distribute your 401(k) in December but forget about a small profit-sharing plan balance. The NUA election fails for the entire distribution.

Pitfall 2: Taking cash instead of shares

If the plan sells the stock and distributes cash, NUA treatment is lost. You must take actual shares in-kind.

Coordination requirement: Work with your plan administrator and receiving brokerage to ensure shares transfer as shares, not as cash proceeds.

Pitfall 3: Selling before distribution settles

NUA treatment applies at the moment of distribution. If you sell shares before they properly transfer to your taxable account, treatment may be unclear.

Best practice: Wait for shares to appear in taxable brokerage and confirm cost basis is recorded correctly before selling.

Pitfall 4: Ignoring state taxes

Some states tax capital gains at ordinary income rates, reducing NUA benefit. California, for example, taxes all income (including capital gains) at rates up to 13.3%.

State analysis: In high-tax states, NUA may provide 7-17% federal savings but 0% state savings, reducing overall benefit.

Pitfall 5: Missing the calendar year deadline

All accounts must be distributed in the same calendar year. A December separation with January distribution processing fails the test.

Timing guidance: Begin the distribution process well before year-end. Plan administrators may require 2-4 weeks to process.

Implementation Checklist

Before Triggering Event

• Request cost basis documentation from plan administrator
• Calculate NUA amount (current value minus cost basis)
• Model tax comparison: NUA vs. full IRA rollover
• Identify all plans of same type with this employer (all must distribute)
• Confirm plan allows in-kind distribution of company stock

At Distribution

• Verify a triggering event has occurred (separation, age 59.5, etc.)
• Confirm distribution will complete within one calendar year
• Specify in-kind stock distribution (not sale within plan)
• Designate receiving taxable brokerage account
• Elect NUA treatment in writing with plan administrator
• Roll non-NUA portion to IRA if using hybrid strategy

After Distribution

• Verify shares arrived in taxable account
• Confirm cost basis is recorded correctly (should equal original plan basis)
• Retain documentation: original basis, NUA amount, distribution date
• Report NUA portion on tax return (Form 1099-R will show distribution)
• Track post-distribution holding period for additional appreciation

Long-Term Considerations

• Decide on sale timing (immediate vs. continued holding)
• Consider gift or estate planning (stepped-up basis opportunity)
• Monitor concentrated stock position risk
• Review state tax treatment for your residence

The NUA strategy converts ordinary income tax into capital gains tax on substantial employer stock holdings. The savings can reach tens or hundreds of thousands of dollars for employees with highly appreciated company stock. The technical requirements demand precision, particularly the one-calendar-year complete distribution rule and in-kind stock transfer mechanics.