Understanding Net Unrealized Appreciation
Net unrealized appreciation is the difference between the cost basis and the current market value of shares of employer stock held in an employer-sponsored retirement account. If you own company stock in your 401(k) or a similar retirement account, you might benefit from net unrealized appreciation (NUA) on your taxes.
The NUA is the difference between what your company stock was worth when you first got it and its value when sold. NUA applies only to your employer's stock because these shares have a distinct cost basis since they are often received through direct employer contributions, such as matches or stock bonuses.
The appreciated value is then taxed at the more favorable long-term capital gains rate. Gains from other 401(k) assets, like investments in mutual funds or exchange-traded funds (ETFs), are taxed as ordinary income when they are eventually sold. NUA offers significant tax savings, especially for high-income earners with a substantial amount of company stock in their retirement plans.
Key Takeaways
Net unrealized appreciation allows the gains from employer stock in retirement accounts to be taxed at long-term capital gains rates. Only the cost basis of employer stock is taxed at ordinary income tax rates. The NUA is the difference between the cost basis and the market price at distribution.
Typically, all tax-deferred retirement assets are taxed as ordinary income upon distribution. The NUA allowance can result in significant tax savings for employees with company shares.
What Is Net Unrealized Appreciation (NUA)?
If you own stock in your employer, you can use NUA to shift part of your tax liability from ordinary income tax rates to the more favorable long-term capital gains rate. For most retirement assets, investments grow tax-deferred and lower your taxable income in the year of each contribution.
However, when this tax deferral eventually comes due, it would be a distribution from a retirement account, which is typically taxed as ordinary income at your marginal tax rate at retirement—regardless of whether the distributed assets are stocks, bonds, mutual funds, or any other investment type. This means that even if the appreciation is from long-term capital gains within the account, all distributions are treated as ordinary income for tax purposes.
NUA is a consideration when you take a lump-sum distribution of company stock from your qualified retirement plan. For example, if you have $100,000 worth of employer stock in your 401(k) plan and you were originally granted 5,000 shares at $4.00 per share, making the cost basis $20,000, then the $80,000 difference is the NUA.
Without the NUA strategy, if you were to sell the entire amount, you would pay ordinary income tax rates (which can be as high as 37%) on the full amount. However, by implementing the NUA strategy, you would pay ordinary income tax only on the cost basis ($20,000), while the $80,000 in gains would be taxed at the long-term capital gains rate, which maxes out at 20%.
Important Consideration
While NUA offers tax benefits, it may lead to an overconcentration in employer stock. Having too much of your savings in employer shares increases risk. Should the company have financial difficulties, that could affect not only the share price but also your employment.
How NUA Is Taxed
Under the Internal Revenue Code, when a qualifying distribution is made from a tax-deferred retirement plan that includes employer stock, the IRS permits a split-taxation method. This means the distribution is divided into two components: the cost basis, which is the original cost of the stock and is taxed as ordinary income in the year of the distribution, and the net unrealized appreciation, which is the increase in value from the cost basis to the market price at the time of distribution and is taxed as long-term capital gains when sold.
Example
Suppose you've built up $400,000 in company stock in your 401(k). You originally received 5,000 shares when they were worth $16 each—that amounts to a $80,000 cost basis. The $320,000 difference is your NUA, which won't be taxed (as capital gains) until the shares are sold.
If the stock keeps going up after the distribution, that will be taxed as usual: short-term gains if held less than a year after distribution or long-term capital if held longer.
Tip
The tax advantages from using NUA become more pronounced for individuals in higher tax brackets.
NUA Requirements and Distribution Rules
Before using the NUA strategy, you'll need to meet a few key conditions. You can only take advantage of NUA when certain life events happen, such as separation from service (for employees), reaching age 59½, total disability (applicable only for self-employed individuals), or death.
Second, you must take the stock as a lump-sum distribution, meaning the entire balance of all qualified plans of the same type must be distributed within a single tax year. However, this doesn't mean you have to take all your company stock at once. You can split the distribution into three streams: distribute it all at once, where you take a direct distribution of some or all the company stock as cash to immediately capture the NUA tax treatment, but you won't benefit from any future price appreciation in the stock; roll it over into a retirement account, where you roll over some of the company stock into an individual retirement account, allowing you to keep deferring taxes but forfeiting the NUA benefit, meaning future withdrawals would be taxed as ordinary income; or roll it over into a regular brokerage account, where you roll over some of the company stock into a taxable brokerage account, preserving the NUA advantage—only the cost basis is taxed at distribution, and future gains benefit from favorable long-term capital gains rates—while providing greater flexibility.
Important Note
A lump-sum distribution can trigger a large year-end tax bill, even with the NUA benefit.
The Bottom Line
Using NUA is a tax strategy that can deliver major tax savings to employees who hold a lot of their company's stock in their qualified retirement plans. It separates the cost basis (taxed as ordinary income) from any price appreciation (taxed as long-term capital gains).
If you are considering the NUA strategy, it would be prudent to first discuss this with a qualified tax professional or financial advisor.
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