How Can Net Unrealized Appreciation Save you Thousands?
If you've spent years building wealth through your employer's retirement plan, particularly by accumulating company stock, there's an overlooked tax strategy that could save you tens of thousands of dollars.
It's called Net Unrealized Appreciation and if you’re nearing retirement, you should understand its basics.
What Is Net Unrealized Appreciation?
Net Unrealized Appreciation (NUA) refers to the difference between the original cost basis of employer stock held in your retirement account and its current market value.
In simpler terms, it's the amount your company stock has grown in value while sitting in your 401(k) or other retirement plan.
Let’s say that over the course of your career, you bought shares of your company's stock through your 401(k) totaling $50,000. Today those shares are worth $250,000, meaning the NUA is $200,000. That $200,000 is growth that hasn't been taxed yet, and the NUA strategy gives you a way to handle that growth when you leave your employer.
Under normal circumstances, withdrawals from a traditional 401(k) are taxed as ordinary income at your current tax rate. The NUA strategy allows you to pay ordinary income tax only on the original cost basis of the company stock, while the appreciation gets more favorable long-term capital gains treatment. This can give you substantial tax savings.
Who Qualifies for NUA Treatment?
The IRS has four specific requirements that must be met to take advantage of NUA treatment.
You must experience a "triggering event" that makes you eligible for a distribution.
Events include reaching age 59½, separating from service with your employer, disability, or death.
You must take a lump-sum distribution of your entire retirement plan balance within a single tax year.
Distribute 100% of the balance from all plans of the same type with your employer. You cannot cherry-pick which assets to distribute or spread the distribution across multiple years.
The stock must be transferred "in-kind" to a taxable brokerage account.
You're not selling the shares and taking cash; you're physically moving them from your retirement account to a regular investment account. Keeping the actual shares is necessary.
The employer stock must have been purchased with employee deferrals or employer contributions.
Shares can’t be rolled over from previous employers. They need to have a genuine connection to your current company.
How does NUA Work?
Let's walk through a more in-depth example.
Sarah, age 62, is retiring from a tech company that she's worked at for 25 years. Her 401(k) balance is $800,000: $500,000 in mutual funds and $300,000 in company stock. The cost basis of that company stock is $75,000, so the NUA is $225,000.
When Sarah leaves her company, she has a few options.
Roll everything into an IRA
If she does this, she loses the NUA opportunity. Every dollar she eventually withdraws from that IRA will be taxed as ordinary income.
Use the NUA strategy
She transfers the $300k of company stock in-kind to a taxable brokerage account and rolls the remaining $500k of mutual funds to an IRA. In the year she makes this transfer, she pays ordinary income tax on the $75k cost basis of the company stock. If she's in the 24% federal tax bracket, that's approximately $18,000 in federal taxes.
The $225k of appreciation isn't immediately taxed. When Sarah eventually sells the stock, the $225,000 will be taxed at long-term capital gains rates, which currently maxes out at 20% federally (plus the 3.8% net investment income tax for high earners). Compare that to potentially 37% if she had rolled everything to an IRA.
If Sarah holds the shares for more than a year after the distribution before selling, any additional appreciation beyond the original $225,000 NUA would also qualify for long-term capital gains treatment. If she sells immediately, the NUA portion is still taxed as long-term capital gains, but any additional appreciation would be short-term.
How to report NUA on tax return?
Forms You Receive
Your employer retirement plan administrator issues a Form 1099-R to report the NUA distribution.
Your financial institution or broker provides a Form 1099-B, which lists the number of shares sold, the sale date, and the proceeds.
What You Report
NUA is included on Line 5a of your 1040 as part of your overall pension and annuity payments. It isn't included as taxable income on Line 5b.
Report the gains from the sale on Form 8949 and Schedule D of your 1040.
One more form may be required (Form 8960) if your modified adjusted gross income (MAGI) is above $200k as a single filer or $250k if married filing joint. If so, the gain on top of the NUA is subject to the 3.8% net investment income tax.
Other Tax Implications
The potential tax savings from NUA treatment can be substantial, but the strategy isn't right for everyone. It depends on your own circumstances.
Consider the difference in tax rates. Currently, long-term capital gains are taxed at 0%, 15%, or 20% depending on your income level, while ordinary income tax rates range from 10% to 37%. For someone in a high tax bracket (like Sarah), converting what would have been ordinary income into capital gains can save 10-17% or more on the appreciated portion of the stock.
However, there are trade-offs. When you execute an NUA distribution, you're paying tax on the cost basis immediately, even if you don't need the money yet. This accelerates taxation that could have been deferred for years in an IRA. You need enough liquid cash to pay this tax bill.
Also, you're moving money from a tax-protected retirement account into a taxable account, where future dividends and capital gains will be taxable annually. This ongoing taxation might not be worth the tax-free growth you'd get in an IRA.
Concentration risk is another concern. The NUA strategy works best when you have a significant amount of highly appreciated company stock, but holding a large portion of your wealth in a single stock is risky. Most advisors will always recommend diversifying your portfolio.
Estate planning adds another layer of complexity. With NUA, your beneficiaries inherit the stock with a stepped-up basis, meaning the NUA portion escapes income taxation if you hold it until death. If you’d rolled everything to an IRA your beneficiaries would pay ordinary income tax on every dollar they withdraw, but they would benefit from extended tax-deferred growth under the SECURE Act's ten-year rule for most beneficiaries.
While NUA gives you the chance to convert what would be highly taxed ordinary income into preferentially taxed capital gains, the strategy that saves one person $100,000 in taxes might cost another person money if their circumstances are different.
NUA requires tax calculations, timing considerations, coordination between different types of accounts, and answering questions like:
Should you sell the stock immediately after distribution or hold it?
How does your current and projected future tax bracket affect the calculation?
How does NUA interact with other retirement income, like Social Security or pension benefits?
If you're married and file jointly, how does your spouse's income factor in?
If you hold significant company stock in your retirement plan and are approaching one of the triggering events we mentioned earlier, now is the time to explore whether NUA makes sense for you. And the decision must be made at the time of distribution, since you can’t go back and fix it later if you miss the opportunity.
As always, we recommend working with a professional who understands both tax strategies and wealth management.
Author: Rob Cucchiaro, CFP, CRPC, AAMS
Questions answered in this blog:
What is Net Unrealized Appreciation?
Who should take advantage of strategy related to Net Unrealized Appreciation?
Are there requirements to qualify for Net Unrealized Appreciation?
What triggering events make you eligible for a distribution?
What does it mean to take a lump-sum distribution of my entire retirement plan balance?
What does it mean for stock to be transferred "in-kind?"
How does NUA work?
What are the tax implications of NUA?
What are the net unrealized appreciation rules?
How to report NUA on tax return?
This material is purely intended to be general and educational in nature, and should not be construed as specifically-tailored investment, financial planning, tax, legal, or other professional advice. Information and data contained herein is as-of the date of publication, and may be subject to change in the future without notice. Any investment performance referenced is purely past performance, which is no guarantee of any future performance. Nothing contained herein should be construed as an offer to sell, a solicitation of an offer to buy, or a recommendation of any security or other financial product or investment strategy. All investment, tax, and financial planning strategies involve risk that you should be prepared to bear. You are highly encouraged to consult with professionals of your choosing before taking any action based on this material.