Net unrealized appreciation (NUA) is the tax-advantaged increase in value of an employee retirement plan at the time you take a lump-sum distribution into a taxable brokerage account. The difference in value is taxed at long-term capital gains rates instead of as ordinary income.
If you have company stock in a retirement plan, conventional wisdom is to roll the plan assets over to an IRA when you retire from or otherwise leave a company. But you may also be able to distribute the stock out of the plan and take advantage of a lower tax rate on a portion of the distributions. Learn how NUA works and when you might be able to use it.
What Is Net Unrealized Appreciation?
When you separate from a company in which you've held a retirement account, you can generally either roll over the assets to an IRA or distribute the stock into a taxable account under special tax rules.
With the first option, any distributions you later take on the assets will be taxed at your ordinary income tax rate. This option also may not even be available, depending on whether there are in-kind accounts that match your employee account. For this reason, many 401(k) plans liquidate the assets in your account and send a check or wire the funds in cash directly to your chosen IRA account when you request a rollover.
In-kind transfers are often unavailable if the investment choices inside a company retirement plan are not available outside the plan.
The second approach, known as the net unrealized appreciation strategy, may afford considerable tax savings over the rollover approach. Under this strategy, you only pay ordinary income tax on the cost basis of the stock; you pay the lower capital gains tax rate on the rest of the distribution, and that too, only when you sell the stock.
NUA Tax Treatment Eligibility Criteria
To qualify for the favorable tax rules of the net unrealized appreciation strategy, you must:
- Have employer securities in a qualified employer-based retirement account. These include company stock in a profit-sharing plan, stock-bonus plan, or pension plan that your employer bought or you purchased with pretax contributions.
- Take a lump-sum distribution from a retirement account as a result of a separation from the company or reaching age 59 1/2. A lump sum is a one-time distribution in one year of the entire balance of all qualified retirement accounts of a certain kind (profit-sharing plans, for example). This can also apply if you're the beneficiary of a plan of someone who dies.
- Take a direct contribution of stock from the plan. In other words, don't roll over the stock to an IRA first and liquidate it. Move it directly into a taxable brokerage account.
How Net Unrealized Appreciation Works
Suppose you have $60,000 of WIDGET stock in your retirement plan. Think of your company stock as composed of three parts:
Cost basis is the price you paid for the shares. For example, assume the cost basis of the total shares you own is $25,000. When you distribute the stock in kind as a lump sum—a payment within a single year of the entire account balance—upon retirement, you would pay tax on the cost basis at your ordinary income tax rate. This means that in the year of distribution, you would report $25,000 of income on your tax return as a pension distribution.
Net Unrealized Appreciation
If the total value on the day of distribution is $65,000, and your cost basis is $25,000, the net unrealized appreciation would be $40,000. Normally, you do not pay tax on this net unrealized gain until you sell the stock, and at that time it will be taxed at the long-term capital gains tax rate even if you sell it right away.
You can make a special election to have the NUA added to your income—and pay the associated capital gains tax—in the year of distribution. This approach may make sense if your income for the current year affords you a low capital gains tax rate and you expect your future income and capital gains tax rate to be higher.
Additional appreciation refers to capital gains earned after you distribute the stock if it continues to increase in price. This additional appreciation is taxed either at the short- or long-term capital gains rates depending on how long you hold the shares after they are distributed from the plan. You have to hold the shares for a minimum of one year to qualify for the lower long-term capital gains tax rates.
How to Determine If NUA Saves You Money
Deciding whether the NUA strategy is the right one for you involves looking at several factors.
The younger you are, the more time there is for assets you roll over to an IRA to grow on a tax-deferred basis, and the less benefit there is in taking the NUA tax treatment because the years of growth may outweigh the lower capital gains tax rates afforded by distributing the stock to a taxable account. The shorter your retirement horizon, the more beneficial the NUA tax treatment is.
Normal 401(k) age-distribution rules apply, and the cost-basis portion of the distribution is subject to early-withdrawal penalty taxes. However, the NUA portion of the distribution isn't subject to this penalty.
The Types of Retirement Accounts You Own
If the majority of your funds are in tax-deferred accounts, then distributing stock with NUA tax treatment may give you the opportunity to develop a greater balance between pretax and post-tax retirement assets. This approach may result in additional tax savings later in your retirement years when required minimum distributions (RMDs) from retirement accounts begin. By lowering the amount of money in qualified retirement accounts, you will be lowering your RMDs.
The NUA Amount
If the cost basis is low and the current value of company stock is high, the NUA will be high, which makes a larger share of distributions eligible for the lower capital gains tax rate.
Your Current and Future Tax Rates
If the ordinary income tax rate when you plan to take distributions from retirement accounts is projected to be quite a bit higher than long-term capital gains tax rates, the NUA strategy may be more favorable.
In most cases, long-term capital gains tax rates top out at 20%. Ordinary income taxes vary based on your income level but can be as high as 37% in 2020.
Be Aware of the Risk
An individual stock in a brokerage account is a far riskier investment than a diversified portfolio. If the company stock represents a large portion of your financial assets and you plan on holding the stock long after distributing it from the plan, you must consider the investment risk this entails alongside your retirement goals.
- Net unrealized appreciation is the increase in value on a lump-sum distribution from an employee retirement plan into a brokerage account.
- The employee's basis in the plan is taxed as ordinary income at the time of distribution.
- The appreciated portion is taxed at the long-term capital gains rate only when the stock is finally sold.
- Individuals who stand to gain the most from the NUA strategy are those closer to retirement and with highly appreciated company stock or higher predicted future tax rates.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.