Key takeaways
Net unrealized appreciation (NUA) refers to the increase in value of employer stock held within an employer-sponsored retirement plan, such as a 401(k) plan. It’s equal to the difference between the stock’s initial purchase price (cost basis) and its value when distributed to the employee.When taking company stock out of a 401(k) or other employer-sponsored retirement plan, you can defer taxes on the NUA portion of your distribution until the stock is sold. At that point, the NUA is taxed at long-term capital gains rates. However, your cost basis in the stock is taxed as ordinary income for the year of the distribution.To take advantage of NUA tax rules, you must take a lump-sum distribution, which involves withdrawing all your company stock from all employer-sponsored retirement plans of the same type in a single tax year. The lump-sum distribution must also be taken because you leave the job, reach age 59½, become disabled, or die.You can opt out of the NUA rules. However, it’s best to consult with a tax professional or financial advisor before deciding whether to opt out or follow the NUA tax rules.
If you hold company stock in your 401(k) or other employer-sponsored retirement plan, you should become familiar with the rules on net unrealized appreciation (NUA). With some careful planning, NUA can offer significant tax savings when it’s time to take money out of your retirement plan.
What is net unrealized appreciation?
NUA is generally the increased value of an employer’s stock from the time it was purchased within an employer-sponsored retirement plan (e.g., a 401(k) or profit-sharing plan) to the time it’s distributed to the employee. NUA is calculated by subtracting the stock’s cost basis from its market value on the day it’s distributed.
For example, suppose you buy a share of your company’s stock through your retirement plan for $10 (cost basis). By the time you’re ready to retire, the stock’s market value has increased to $50. The $40 increase in value is the NUA ($50 – $10 = $40).
If you pay different amounts for company stock over time (which is usually the case), use your average cost basis to calculate your NUA.
Tax treatment of net unrealized appreciation
When you retire or otherwise leave your job, there are a number of things you can do with the money in your 401(k). You can leave it in the account. You can roll it over into an IRA, another 401(k) account, or a brokerage account. If you need the money right away, you can cash out and spend it all. Or you can do a combination of these options.
If you transfer funds to a brokerage account or a Roth IRA, or simply cash out, you’ll have to pay tax on the money for the tax year you withdraw it from your former employer’s 401(k) plan (assuming you didn’t have a Roth 401(k) account). The “ordinary” income tax rates apply, which currently range from 10% to 37% depending on your federal tax bracket.
On the other hand, if you leave your money in the existing account, or transfer it to a traditional IRA or 401(k), you won’t have to pay tax on the money until you withdraw it. At that point, the money will be taxed at your ordinary tax rate (again, assuming you’re not withdrawing the money from a Roth account). This ability to defer taxes until later is why most people prefer to hold their money in an IRA or 401(k) account after they leave their job.
However, if your 401(k) account (or other employer-sponsored retirement plan) includes shares of your employer’s stock, you might be better off transferring those shares to a brokerage account or cashing out when you leave your job. That’s because the NUA tax rules can be used to reduce the immediate tax hit and apply the more-favorable long-term capital gains tax rates (0%, 15%, or 20%) when you eventually sell the employer stock.
Here’s how the NUA rules generally work:
If you pull the company stock out of your former employer’s 401(k) plan in a lump-sum distribution, tax is deferred on the NUA until you sell the stock (you still must pay tax on your cost basis at your ordinary tax rate),When you do sell the company stock, the NUA is taxed at the rates for long-term capital gain, andAny gain exceeding the NUA (i.e., gain since taking the stock out of the former employer’s 401(k) plan) is taxed as long-term or short-term capital gain, depending on how long you held the stock after pulling it out of the 401(k) account (short-term gains are taxed at your ordinary tax rate).
If there isn’t a lump-sum distribution, tax is only deferred on NUA resulting from nondeductible employee contributions. Any NUA resulting from deductible voluntary employee contributions is taxed in the year of the distribution.
Also note that you can elect to include NUA in your taxable income for the tax year you receive it. If you were born before January 2, 1936, and go this route, you might be able to figure the tax on your NUA using an alternative method (i.e., “20% capital gain election” or “10-year tax option”).
TurboTax Tip: The 3.8% surtax on net investment income doesn’t apply to NUA. However, it does apply to any increase in the company stock’s value after it’s taken out of your 401(k) or other employer-sponsored retirement plan.
Lump-sum distribution for purposes of the NUA rules
For purposes of the NUA rules, a lump-sum distribution is a distribution or payment of your entire balance – within a single tax year – from all of your employer’s qualified plans of a single kind (e.g., pension, profit-sharing, or stock bonus plans). You must also be taking the distribution because you:
Left your job,Reached age 59½,Became totally and permanently disabled (self-employed workers only), orDied.
However, you can still apply the NUA rules if funds in your 401(k) account that aren’t company stock are rolled over into an IRA or another 401(k) plan. That way, you can still defer taxes on those amounts if they’re separated from the company stock before the rollover.
Example of net unrealized appreciation rules
To show how the NUA rules can save you money, let’s take a look at a few of the different options you have if you leave a job and have company stock in a 401(k) or other employer-sponsored retirement account.
For all the options, assume you have a 401(k) plan that holds 1,000 shares of your company’s stock. The average cost of each share is $25, so your total cost basis for the shares is $25,000 (1,000 x $25 = $25,000). On the day you leave your job, the stock is worth $130,000. As a result, your NUA is $105,000 ($130,000 – $25,000 = $105,000). In addition, you’re in the 24% federal tax bracket and your long-term capital gains are taxed at the 15% rate for the tax year you leave your job and the following five years.
Option #1 – Roll over the company stock into a traditional IRA. You roll over all the company stock into a traditional IRA, which means tax on the stock is deferred until the year it’s sold. Two years later, the IRA sells the stock for $150,000, and you then withdraw that amount from the account. Since the NUA rules don’t apply, you’re taxed at a 24% rate on the $150,000 distribution for the tax year you receive it. That results in a $36,000 tax bill ($150,000 x .24 = $36,000).
Option #2 – Cash out the company stock. You cash out the company stock in a lump-sum distribution and receive $130,000 when you leave your job. Under the NUA rules, the $25,000 cost basis is taxed that year at the 24% rate. That results in $6,000 of tax ($25,000 x .24 = $6,000). The $105,000 of NUA is taxed that year at the 15% rate for long-term capital gains, which results in $15,750 of tax ($105,000 x .15 = $15,750). Therefore, the combined total of tax on the company stock is $21,750 ($6,000 + $15,750 = $21,750).
Option #3 – Transfer the company stock into a brokerage account; sell it two years later. You take a lump-sum distribution of all the company stock and put it in a brokerage account. Under the NUA rules, the $25,000 cost basis is taxed that year at the 24% rate, which results in $6,000 of tax ($25,000 x .24 = $6,000). Two years later, you sell the stock for $150,000. At that point, the $105,000 of NUA is taxed at the 15% rate for long-term capital gains, which results in $15,750 of tax ($105,000 x .15 = $15,750). Since you held the stock in the brokerage account for more than one year, the additional $20,000 of gain since the transfer ($150,000 – $130,000 = $20,000) is also taxed at the 15% rate for long-term capital gains, which results in an additional tax of $3,000 for the tax year the stock is sold ($20,000 x .15 = $3,000). Therefore, the combined total of tax on the company stock is $24,750 ($6,000 + $15,750 + $3,000 = $24,750).
Option #4 – Transfer the company stock into a brokerage account; sell it 11 months later. You take a lump-sum distribution of all the company stock and put it in a brokerage account. Under the NUA rules, the $25,000 cost basis is taxed that year at the 24% rate, which results in $6,000 of tax ($25,000 x .24 = $6,000). Eleven months later, you sell the stock for $150,000. At that point, the $105,000 of NUA is taxed at the 15% rate for long-term capital gains, which results in $15,750 of tax ($105,000 x .15 = $15,750). Since you held the stock in the brokerage account for one year or less, the additional $20,000 of gain since the transfer ($150,000 – $130,000 = $20,000) is taxed at the 24% ordinary rate for short-term capital gains, which results in an additional tax of $4,800 for the tax year the stock is sold ($20,000 x .24 = $4,800). Therefore, the combined total of tax on the company stock is $26,550 ($6,000 + $15,750 + $4,800 = $24,750).
As you can see, using the NUA rules can save you money under a variety of different circumstances. The highest overall tax bill ($36,000) comes with Option #1, when you roll over the company stock into a traditional IRA. In that case, the NUA rules don’t apply.
With all the other options, the NUA rules work to lower your overall tax liability. You can also see how holding the company stock for more than one year after you withdraw it from your former employer’s 401(k) plan can save you even more money ($24,750 vs. $26,550 of tax). Also note that, even though you might have the lowest tax bill if you cash out immediately ($21,750), you won’t earn any additional income after withdrawing funds from your old 401(k) plan – so you might not be in a better financial position in the end.
How to report net unrealized appreciation
If you have NUA from a distribution of company stock from a 401(k) or other employer-sponsored retirement plan, it will be shown in Box 6 of the Form 1099-R you receive from the plan administrator. If you didn’t receive a lump-sum distribution, only the NUA resulting from your own contributions will be included in Box 6.
On your Form 1040 for the year the company stock is distributed, NUA is included on Line 5a as part of your overall pension and annuity payments. However, it generally isn’t included as taxable income on Line 5b if you’re taking advantage of the NUA rules.
However, if you choose to include NUA in your taxable income for the year you receive it, and you were born before January 2, 1936, use Form 4972 to calculate the tax on your NUA using the 20% capital gain election or the 10-year tax option.
Net unrealized appreciation strategies
So, when can the NUA rules save you the most money…and when might you be better off rolling over company stock into an IRA?
Assuming you can afford to pay tax on your cost basis in the company stock, here are a handful of situations when you might want to apply the NUA rules:
Company stock’s value has grown significantly. The NUA tax rules can provide significant tax savings if the value of the company stock has grown a lot. This is especially so if your cost basis in the stock is much lower than the stock’s market value when you withdraw it from your plan.
High percentage of company stock in your retirement plan. You’ll also want to consider applying the NUA rules if a large percentage of your total retirement plan balance consists of NUA. That’s because a larger amount of the growth will be subject to the lower capital gains tax rates, rather than ordinary income rates.
You’re in the highest tax bracket. Higher-income workers can benefit more from the NUA rules, too. That’s because the gap between their ordinary income tax rate (up to 37%) and their long-term capital gains tax rate (20% maximum rate) are likely to be the greatest.
Cash needed immediately. If you need to cash out the stock when you leave your job, you may be better off taking a lump-sum distribution and applying the NUA rules compared to opting out of the NUA rules and taking the distribution as taxable income.
However, even if all this sounds too good to pass up, there still could be reasons why you might not want to apply the NUA rules. Here are a few examples of circumstances under which you might not want to trigger the NUA rules:
Deferring all taxes for as long as possible. If your goal is to push back the payment of all taxes for as long as possible, then you might want to keep the company stock in the existing retirement account, or roll it over into a traditional IRA or other 401(k) plan. That way you can defer payment of taxes on the cost basis as well as on the NUA. Future gains will also be deferred. You might want to take this route if you expect to be in a significantly lower tax bracket down the road (e.g., in retirement).
Diversifying your retirement savings. If too much of your retirement savings is tied up in company stock, and perhaps you don’t think there’s a lot of growth to be had with that stock, you might want to sell off some of the stock and diversify your portfolio. In that case, it might not make sense to take a lump-sum distribution of all your company stock. And without a lump-sum distribution, you might not be able to apply the NUA rules.
Short on funds when you leave the company. If you follow the NUA rules, you’ll still have to pay tax at the ordinary income tax rates on your cost basis in the company stock for the year you withdraw the stock. If that will create financial hardship, it might be better to keep the stock in a traditional IRA or 401(k) plan that continues to shield the stock from tax.
There can be other pros and cons of using the NUA rules. As a result, you might want to check with a qualified tax professional or financial advisor before picking the path that’s right for you.
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