Company Stock in Your 401k: What Are the Tax Rules?
The tax treatment for company stock in a 401(k) differs from other assets. Understand the financial implications of your distribution choices.
Many employer-sponsored retirement plans offer the option to invest in the company’s own stock. This can happen through direct employee contributions, employer matching funds, or profit-sharing programs. Holding employer securities within a 401(k) aligns an employee’s financial interests with the company but also presents different considerations than other investments, as the value of this portion of a retirement portfolio is directly tied to the fortunes of a single company.
Understanding Net Unrealized Appreciation (NUA)
Net Unrealized Appreciation (NUA) is a tax opportunity for company stock held within an employer-sponsored retirement plan. It is the difference between the stock’s value when it was acquired in the plan, known as the cost basis, and its fair market value at the time it is distributed. To illustrate, imagine an employee has company stock in their 401(k) with a cost basis of $50,000. Over the years, the company performs well, and by the time the employee is ready to take a distribution, the shares are worth $250,000. The NUA in this scenario is $200,000, which is the market value ($250,000) minus the cost basis ($50,000).
The benefit of the NUA rule is the potential tax savings. Normally, money withdrawn from a traditional 401(k) is taxed as ordinary income. With an NUA-eligible distribution, only the cost basis of the stock is taxed at ordinary income rates in the year of distribution. The NUA portion is not taxed until the shares are sold, at which point the gain is taxed at lower long-term capital gains rates. This treatment contrasts with rolling the same company stock into an IRA, where the entire $250,000 would eventually be taxed as ordinary income. This provision, outlined in Internal Revenue Code Section 402, applies only to employer securities from a qualified plan.
Requirements for NUA Tax Treatment
To qualify for NUA tax treatment, the IRS imposes several strict criteria. A primary condition is the need for a lump-sum distribution, meaning the entire vested balance of all of an employee’s similar qualified plans with that employer must be distributed within a single calendar year. For example, if an employer offers both a 401(k) and a profit-sharing plan, the total account balances from both must be paid out in the same year to satisfy this rule. It is not possible to take a partial distribution and qualify.
The distribution must also be prompted by a specific triggering event. The four qualifying events are:
- Separation from service, such as retirement or changing jobs
- Attaining age 59½
- Death
- Disability
Finally, the distribution of the company stock must be made “in-kind.” This means the actual shares of stock must be moved from the 401(k) account directly into a taxable brokerage account. The shares cannot first be sold inside the 401(k) with the resulting cash then moved to the brokerage account, as this would disqualify the NUA treatment.
The Distribution Process and Tax Reporting
To use the NUA strategy, you must provide specific instructions to your 401(k) plan administrator. The employee must direct the administrator to perform a split distribution. This involves transferring the company stock shares in-kind to a non-retirement, taxable brokerage account. Simultaneously, all other assets in the 401(k), such as mutual funds and cash, should be processed as a direct rollover into an Individual Retirement Account (IRA) to maintain their tax-deferred status.
After the distribution is complete, the plan administrator will issue IRS Form 1099-R, “Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.” This form is essential for tax reporting. Box 1 will show the gross distribution amount, which is the total value of the stock at the time of distribution. Box 2a reports the taxable amount, which is simply the cost basis of the shares.
The amount of the Net Unrealized Appreciation is reported in Box 6 of Form 1099-R. This figure should equal the amount in Box 1 minus the amount in Box 2a. Box 7 contains a distribution code that signifies the reason for the payout, such as a normal distribution or one due to death.
Post-Distribution Tax Implications
In the tax year of the distribution, the cost basis of the shares is subject to ordinary income tax. A 10% early withdrawal penalty may also apply to this amount if the distribution occurs before age 59½ and no exception applies.
The more significant tax implications arise when the shares are eventually sold from the taxable brokerage account. The portion of the gain attributable to the NUA is taxed at long-term capital gains rates, regardless of how long the shares were held in the brokerage account after the distribution. Any additional appreciation in value that occurs after the date of distribution is treated differently. This subsequent gain is subject to capital gains tax, but the rate depends on the holding period. If the shares are sold one year or less from the distribution date, the gain is considered short-term and taxed at ordinary income rates; if held for more than one year, the gain qualifies for the lower long-term capital gains rates.
Continuing the earlier example, the $50,000 cost basis is taxed as ordinary income in the year of distribution. The $200,000 NUA is not taxed until the shares are sold, at which point it will be taxed at long-term capital gains rates. If the shares, now in a brokerage account, grow to be worth $300,000 and are sold more than a year later, the additional $50,000 of growth is also taxed at long-term capital gains rates.