What Is Net Unrealized Appreciation (NUA)?
Learn how NUA can benefit you at tax time
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 using a tax-calculation metric known as net unrealized appreciation (NUA).
Basics of Net Unrealized Appreciation
Employees can take one of two main approaches to handle company stock in a retirement account when they separate from a company:
- Roll over the assets "in kind" (in non-cash forms such as stock) or in cash to an IRA
- Distribute the stock into a taxable account under special tax rules (you can usually still roll over the remaining non-stock assets to an IRA)
With the first option, any distributions you later take on the assets will be taxed at your ordinary income tax rate. But that's not the only downside. While an increasing number of 401(k) plan providers now offer the in-kind rollover option where shares of the investments you own inside the 401(k) are transferred as shares to your IRA, there is no guarantee that your 401(k) plan will allow an in-kind rollover. In-kind transfers are often unavailable if the investment choices inside a company retirement plan are not available outside the plan.
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.
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 pre-tax contributions.
Take a lump-sum distribution from a retirement account as a result of a separation from the company or reaching age 59.5. 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).
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.
How Net Unrealized Appreciation Helps You Manage Stock
It takes some calculation to determine if this special tax treatment will benefit you. To understand how it works, let’s walk through an example.
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. Your employer can provide you with this number if you don't know it. 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, $25,000 of income would be reported on your tax return as a pension distribution.
Net unrealized appreciation is the difference between the cost basis and the market value when the stock is distributed from the plan. Assume that the day the stock is distributed; the total value of your shares is $60,000. As your cost basis is $25,000, the net unrealized appreciation would be $35,000. 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 at 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 the NUA Tax Treatment Saves You Money
Take these factors into account as you make your decision.
Consider your age. 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. But unlike the cost-basis portion of the distribution, which is subject to early-withdrawal penalty taxes, the NUA portion of the distribution isn't subject to this penalty.
Survey the types of retirement accounts you own. If the majority of your funds are in tax-deferred accounts (traditional 401ks, IRAs, 457s, 403bs, for example), then distributing stock with NUA tax treatment may give you the opportunity to develop a greater balance between pre-tax 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 retirement accounts, you will be lowering your RMDs.
Assess the NUA amount. If the cost basis is low and the current value of company stock is high (for example), the NUA will be high, which makes a larger share of distributions eligible for the lower capital gains tax rate.
Think about your future tax rate. 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.
Be aware of the risk. An individual stock 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.
Online net unrealized appreciation calculators such as the Pacific Life calculator can help you put a number on the potential savings of taking the NUA treatment versus rolling over your assets to an IRA. However, a customized analysis that factors in your annual projected marginal tax rates, projected capital gains rates, and distributions on a year-by-year basis can produce more accurate results for your specific situation. Consult a qualified retirement planner or another tax specialist for help with this analysis.
The Bottom Line
Net unrealized appreciation can save you money when you adopt it in your distribution strategy for a retirement account with company stock. It may allow you to pay a lower tax rate on a portion of the distribution.
When deciding whether to use the NUA strategy versus roll over assets to an IRA, it's helpful to consider your eligibility and a variety of factors specific to your financial profile. Individuals who stand to gain the most from the NUA strategy are the young and those with highly appreciated company stock or higher predicted future tax rates. However, a customized analysis by a qualified retirement planner or tax specialist is recommended to crunch the numbers and make an informed decision about the strategy that is best for your retirement goals.