Net Unrealized Appreciation (NUA)

Net unrealized appreciation (NUA) is the increase in value of employer stock held inside a tax-deferred retirement plan. It’s the difference between the stock’s cost basis (what you originally paid or what was reported as income when the stock was contributed) and its market value at the time of distribution. NUA can produce significant tax savings because the appreciation is eligible for long-term capital gains treatment when the shares are later sold, while the cost basis is taxed as ordinary income at distribution.

How NUA works — the basics

• Applies only to employer stock held in a qualified retirement plan (for example, company stock in a 401(k)).
• NUA is realized when the company stock is distributed out of the retirement plan in a qualifying distribution.
• At distribution, tax is split:
• Cost basis: taxed as ordinary income in the year of distribution.
• NUA (the appreciation up to the distribution date): taxed as long-term capital gains when the shares are sold.
• Any price appreciation after the distribution is taxed normally as short-term or long-term capital gain depending on how long you hold the shares after distribution.

Example: If you received 5,000 shares when they were $4.00 each (cost basis = $20,000) and the shares are worth $100,000 at distribution, the NUA is $80,000. You would pay ordinary income tax only on $20,000 at distribution; the $80,000 gain would be taxed at long-term capital gains rates when you sell the shares.

Tax treatment — key points

• Ordinary income tax is paid only on the cost basis at distribution.
• The NUA portion is taxed as long-term capital gains when the stock is sold—regardless of how long you held the shares inside the plan prior to distribution.
• Gains that occur after the distribution are taxed based on the holding period after distribution (short-term if held under one year, long-term if over one year).
• The benefit is generally greater for taxpayers in higher ordinary-income tax brackets.

Eligibility and distribution rules

To use the NUA strategy you must meet qualifying events and distribution requirements:
Qualifying events (examples)
* Separation from service (employment termination)
* Attaining age 59½
* Total disability (rules differ for self-employed plans)
* Death

Distribution rules
* The NUA election applies when you take a lump-sum distribution. A lump-sum distribution generally means distributing the entire balance of all qualified employer plans of the same type within a single tax year.
* You must receive the employer stock as a distribution (in-kind) to capture the NUA treatment. Options at distribution often include:
* Take the stock as a lump-sum distribution (preserves NUA; ordinary income on cost basis now; NUA taxed as capital gains when sold).
* Roll the stock into an IRA (forfeits NUA — future distributions from the IRA are taxed as ordinary income).
* Transfer the stock into a taxable brokerage account (if done correctly, this can preserve the NUA treatment while giving flexibility).

Important cautions
* A lump-sum distribution can create a sizable ordinary-income tax bill in the year of distribution (on the cost basis and any other ordinary-income items included).
* Preserving NUA often requires receiving the actual shares and not rolling them into an IRA; follow plan rules and IRS requirements carefully.

Pros and cons

Pros
* Potentially large tax savings: appreciation taxed at long-term capital gains rates rather than ordinary income rates.
* Helpful for high-income individuals with concentrated employer stock positions.

Cons
* Concentration risk: holding a large portion of your net worth in employer stock increases exposure to company-specific risk (both to your job and to your retirement assets).
* Complexity: rules are specific and mistakes (for example, improper rollover) can forfeit the NUA benefit.
* Upfront tax on cost basis: may trigger a large ordinary-income tax bill in the distribution year.

How taxes are calculated (simple steps)

1. Determine cost basis of employer stock in the plan.
2. Determine market value at the time of distribution.
3. Cost basis is reported as ordinary income in the distribution year.
4. NUA (market value minus cost basis) is not taxed at distribution; it is taxed as long-term capital gain when you sell the shares.
5. Any gain after distribution is taxed as short-term or long-term capital gain based on the post-distribution holding period.

Practical tips

• Consider the timing of the distribution and your expected tax bracket for the distribution year.
• Evaluate diversification needs — consider selling some shares after distribution (watch holding-period rules for capital gains).
• Keep careful records of the cost basis reported at distribution and plan documents showing the distribution method.
• Consult a tax professional or financial advisor before electing NUA to ensure eligibility and to model the tax consequences.

Bottom line

NUA can offer substantial tax advantages when you hold appreciated employer stock in a qualified retirement plan and meet the distribution requirements. The strategy separates ordinary-income taxation of the original cost basis from capital-gains taxation of the appreciation—but it involves specific timing, distribution rules, and concentration risk. Get professional advice to determine whether NUA makes sense for your situation.

Sources
* Internal Revenue Service — Net Unrealized Appreciation in Employer Securities
* Internal Revenue Service — 401(k) Plans
* Internal Revenue Service — Publication 575, Pension and Annuity Income