The NUA 401k Strategy for Your Company Stock
Holding company stock in your 401(k)? A specific tax rule can convert appreciated value from ordinary income rates to lower long-term capital gains rates.
Net Unrealized Appreciation (NUA) is a tax strategy for employer stock held within a retirement plan. It represents the growth in the stock’s value from its purchase price to its current market value. The NUA rules allow this growth to be taxed at potentially lower long-term capital gains rates instead of the ordinary income rates that apply to 401(k) withdrawals, which can result in tax savings.
Eligibility Requirements for NUA
To qualify for NUA tax treatment, several requirements must be met. The strategy only applies to securities, such as common stock, issued by the employer and held within a qualified retirement plan like a 401(k), profit-sharing plan, or Employee Stock Ownership Plan (ESOP). The NUA rules cannot be used for assets held in an Individual Retirement Account (IRA), even if that IRA holds employer stock that was previously rolled over.
A qualifying triggering event must occur in the year the distribution is made. The four events recognized by the IRS are:
- Separation from service, such as retirement or changing jobs
- Reaching age 59½
- The employee’s death
- The employee becoming totally and permanently disabled
Another requirement is a lump-sum distribution, which means the entire balance of all of an employee’s qualified plans of a similar type with that employer must be distributed within a single calendar year. For example, if an employee has both a 401(k) and a profit-sharing plan with the same company, the balances of both accounts must be fully distributed in the same year. Failing to meet this single-year distribution requirement will disqualify the NUA treatment.
Calculating the NUA Tax Treatment
The first component of the tax calculation is the cost basis of the employer stock, which is the price the retirement plan originally paid for the shares. This information is available on account statements or from the plan administrator. When an NUA distribution occurs, the cost basis is immediately taxable as ordinary income in the year of the distribution.
The NUA is the second component, calculated by subtracting the cost basis from the stock’s fair market value on the distribution day. This NUA amount is not taxed at the time of distribution. It becomes taxable at long-term capital gains rates only when the shares are eventually sold, regardless of how soon that sale occurs.
For example, an employee has $500,000 of company stock in their 401(k) with a cost basis of $100,000, making the NUA $400,000. With the NUA strategy, the employee takes an in-kind distribution. They would immediately pay ordinary income tax on the $100,000 cost basis, which at a 22% rate is $22,000. The $400,000 NUA is taxed at the long-term capital gains rate (e.g., 15%) only when sold, for a tax of $60,000, making the total tax $82,000.
By comparison, rolling the $500,000 into a traditional IRA would result in no immediate tax. However, all future withdrawals would be taxed as ordinary income. At the same 22% rate, the total tax liability would be $110,000, meaning the NUA strategy offers a potential savings of $28,000 in this scenario.
The NUA Distribution Process
Before initiating the distribution, the individual must establish two separate accounts. The first is a taxable brokerage account to receive the shares of employer stock. The second is a traditional IRA to receive all other assets from the 401(k), such as cash or mutual funds.
Once the accounts are ready, contact the 401(k) plan administrator with specific instructions. The request must specify a “lump-sum distribution” and direct the administrator to perform two actions. First, execute a direct rollover of all non-stock assets into the traditional IRA. Second, process an “in-kind” distribution of the employer stock, transferring the shares directly into the taxable brokerage account.
After the administrator processes the request, verify the transactions. Check that the non-stock assets have been rolled into the traditional IRA and that the correct number of employer stock shares are in the brokerage account. Reviewing statements from all accounts will confirm the distribution was executed correctly.
Post-Distribution Tax Reporting and Stock Management
After the distribution, the plan administrator will issue Form 1099-R. This form reports the transaction details to you and the IRS. Box 1 shows the gross distribution amount (the stock’s market value), while Box 2a reports the taxable amount, which is the cost basis. The NUA amount is typically shown in Box 6, and Box 7 contains a code indicating the nature of the distribution.
The tax consequences of selling the stock depend on timing. The original NUA portion is always taxed at the long-term capital gains rate, regardless of when the stock is sold. Any appreciation in value that occurs after the distribution date is treated separately and has its own holding period starting on that date.
If the stock is sold within one year of the distribution, this subsequent gain is a short-term capital gain taxed at ordinary income rates. If the stock is held for more than one year after distribution, this additional appreciation also qualifies as a long-term capital gain.
If the owner of the stock passes away, specific tax rules apply to the beneficiary. The beneficiary who inherits the stock is responsible for paying the long-term capital gains tax on the NUA portion when they sell the shares. However, any appreciation that occurred between the original distribution date and the owner’s date of death receives a step-up in basis, meaning the beneficiary will not owe capital gains tax on that growth.