Net unrealized appreciation (NUA): the employer-stock tax break, done right

What net unrealized appreciation is

Net unrealized appreciation is the difference between what your employer securities are worth on the day they leave the plan and what the plan paid for them. Bought at $100,000, worth $500,000 on distribution: the NUA is $400,000. On its own that is just an accounting figure. What makes it a planning term is IRC §402(e)(4)(B), which says that when a lump-sum distribution includes employer securities, the net unrealized appreciation attributable to them is excluded from gross income at the time of distribution.

That single exclusion changes the character of the money. Everything inside a pre-tax retirement account normally loses its character on the way out — thirty years of stock appreciation comes out as ordinary income, which is why an RMD is never taxed at capital-gains rates no matter what the account held. Employer stock distributed under the NUA rules is the exception. The growth keeps its identity as capital gain, and the IRS states the trade plainly: you pay tax on the cost basis at distribution, and the NUA is taxed as long-term capital gain when you sell the stock (IRS Topic no. 412).

Two details do most of the work. First, there is no holding-period requirement for the NUA portion — you can sell the shares the next morning and the NUA is still long-term gain. IRS Notice 98-24 settles that: the NUA is treated as gain from an asset held long-term "to the extent such appreciation is realized in a subsequent taxable transaction," without calculating the plan's actual holding period. Second, the election applies share by share. You are not obliged to use it on the whole position — a plan will usually let you designate high-basis lots for rollover and low-basis lots for the taxable transfer.

The four net unrealized appreciation rules

All four have to hold. Miss one and the whole distribution is ordinary income.

Source: IRS Topic no. 412 — lump-sum distributions and IRS Publication 575, "Distributions of employer securities."

The fourth row is the one that changes decisions. People assume NUA means abandoning the IRA rollover and taking a $1.4 million tax hit. It does not. The lump sum can be split: shares out in kind, everything else direct-rolled. Only the basis in the shares you designate is taxable. The wider question of what to do with the rest of the account belongs to what to do with a 401(k) after leaving a job, which covers the rollover mechanics, the rule of 55 and the creditor-protection trade-offs; this page assumes you have read it.

Worked example: $500,000 of stock, $100,000 of basis

Take a 60-year-old who has just separated from service. Her 401(k) holds $500,000 of employer stock with a plan cost basis of $100,000, so the NUA is $400,000 — a basis ratio of 20%. She expects to hold the shares roughly ten years, then sell. Assumptions, stated so you can change them: a 37% federal ordinary rate (the top 2026 bracket, which begins above $640,600 of taxable income for a single filer), a 20% long-term capital-gains rate plus the 3.8% net investment income tax for a combined 23.8%, a 6% annual pre-tax return, and no state tax. Both paths are equalised: the ordinary tax due up front in the NUA path is money the rollover path still has, so it is invested alongside.

Three things are worth reading out of that table. The upfront $37,000 is real and has to be paid from cash outside the plan — paying it from the shares themselves means selling them, which wastes the point of the exercise. The saving does not come from deferral, because the IRA defers more; it comes entirely from the 13.2-point rate gap between 37% and 23.8% applied to the appreciation. And the arithmetic here deliberately ignores dividends. Company stock in a taxable account throws off dividends that are taxed every year, while the IRA compounds untouched; at a 1.8% yield taxed at 23.8%, the twenty-year advantage in this example falls from roughly $99,000 to roughly $64,000. Model the drag before you decide. The calculator will price the distribution year for you.

When NUA loses

The election is not close to universally good, and the sales pitch for it usually skips the two variables that decide it: the basis ratio and the rate you would otherwise pay later.

On these assumptions the break-even basis is about 33% of the share value if you stay in the top bracket, and the election turns negative at every basis ratio once your future ordinary rate falls to 24%. That last column is the one advisers skip. A retiree who will spend the next decade drawing from an IRA in the 22–24% brackets is comparing 24% ordinary tax to 23.8% capital-gains tax — there is nothing left to win, and she has paid 37% up front for the privilege. NUA is a strategy for people whose future ordinary rate stays high, which in practice means large pre-tax balances, a working spouse, or the years after RMDs begin.

The traps that kill the election

• A partial rollover taken first. This is the one that ends the conversation. Once you have taken any distribution from the plan after the triggering event, the later distribution is no longer of the entire balance, and the lump-sum requirement fails for that triggering event. The IRS is direct: you generally cannot use the NUA rule once the stock has been rolled into an IRA or another plan (Topic 412). Inside an IRA the appreciation becomes ordinary income permanently, with no way back.
• Crossing a tax year. A lump sum is a distribution made within one taxable year. Shares in December and cash in January is two years and no election. Start the paperwork with enough runway that a settlement delay cannot straddle 31 December.
• Letting the plan sell the shares. Cash proceeds are an ordinary distribution. The instruction to the recordkeeper must be an in-kind transfer of certificated or DTC-eligible shares to a named taxable brokerage account.
• Post-distribution appreciation starts a fresh holding period. Only the NUA measured at distribution is automatically long-term. Gain above that follows your actual holding period from the distribution date (Notice 98-24) — sell within twelve months and that slice is short-term, taxed at ordinary rates.
• The 3.8% NIIT. The eventual sale is net investment income. Add 3.8% once modified AGI passes $200,000 single or $250,000 joint, and remember a large sale can push you over the line by itself.
• Taking shares while still employed. An in-service withdrawal is not a triggering event unless you have reached 59½, and taking one before you separate can consume the balance you needed for the lump sum.

The 10% penalty on the basis portion

Because the basis is a taxable distribution, the 10% additional tax on early distributions under §72(t) can apply to it — but only to it. The excluded NUA is not includible in income, so it is not part of the amount the penalty is calculated on. On a $100,000 basis that is a $10,000 exposure, not $50,000.

Two exceptions usually solve it. If you are 59½ or older, there is nothing to worry about. If you separated from service in or after the year you turned 55, the separation-from-service exception applies to distributions from that employer's plan, which is the ordinary case for someone retiring early with company stock. Below 55, price the $10,000 into the comparison. The full exception list is in the 401(k) early withdrawal penalty guide.

No step-up at death on the NUA

This is the most expensive detail in the subject and it is routinely stated backwards. Appreciated stock in a taxable account normally receives a basis step-up at death, wiping out the built-in gain for heirs. The NUA portion does not. It is treated as income in respect of a decedent under §691, so a beneficiary who inherits the shares inherits the NUA tax with them and pays capital-gains tax on it when they sell.

What does step up is the appreciation that accrued after the distribution. So the shares in the earlier example, inherited at $895,424, would leave a beneficiary with the original $400,000 of NUA still taxable and the $395,424 of post-distribution growth stepped up. The planning consequence is straightforward: if the shares are earmarked for heirs rather than for spending, a large part of the NUA advantage is a deferral rather than a saving — and the calculation should be run on that basis. If they are earmarked for charity, the NUA shares are close to an ideal gift, because the charity pays nothing on the embedded gain.

NUA in an ESOP

An ESOP is a qualified defined contribution plan invested primarily in employer securities, so NUA works there on identical terms — and it is where the numbers are usually most attractive, because leveraged ESOP shares are often allocated at a basis far below their eventual value. Two ESOP-specific problems recur. Many ESOPs distribute account balances in instalments over several years, which by definition is not a lump-sum distribution; if instalments are the default, ask whether a single-year distribution is available before you assume the election exists. And in a private company the shares carry a put option back to the employer, so the "hold and let it grow" half of the strategy may simply not be available — the shares are sold, and the question collapses to whether the NUA rate on that sale beats ordinary rates on a rollover. Often it still does; just do not plan around a long hold you cannot execute.

How it appears on Form 1099-R

The distribution generates a Form 1099-R in which box 6 reports the net unrealized appreciation in employer securities — the amount excluded from your income (IRS instructions for Forms 1099-R and 5498). Box 1 shows the gross distribution including the full share value; box 2a, the taxable amount, should show only the cost basis of the shares plus any other taxable cash. Box 7 will normally carry a distribution code reflecting the reason for the distribution.

Check three things in January. That box 6 is populated at all — an empty box 6 usually means the recordkeeper processed a plain distribution and the election was not recorded. That box 2a excludes the NUA. And that you have kept the plan's cost basis statement, because your broker will hold the shares with a basis equal to that figure and you will need it to compute gain on sale, possibly decades later. If box 6 is blank on a distribution you intended to be an NUA election, raise it with the plan immediately; a corrected 1099-R is far easier than arguing the point on audit.

A decision rule of thumb

Not a substitute for running the numbers with a CPA before anything leaves the plan, but a fast screen for whether it is worth running them:

1. Basis under roughly 30% of the share value. Above about a third, the up-front ordinary tax swallows the rate arbitrage on these assumptions.
2. You expect to stay in a high ordinary bracket. If your retirement withdrawals will be taxed at 24% or below, the election usually costs money.
3. You will realise the shares within about 10–15 years. Beyond that, the IRA's untaxed compounding and the taxable account's annual dividend drag start closing the gap — unless the shares are going to charity.
4. You can pay the up-front tax from outside cash. Funding it by selling the shares defeats the point.
5. You are comfortable with the concentration, or intend to diversify immediately, which the rules permit at no extra tax cost.
6. Nothing has left the plan yet. If a partial rollover has already happened, stop — there is nothing to model.

Where this sits in a wider plan — alongside mega-backdoor contributions, deduction-offset conversions and the charitable moves — is covered in the advanced HNW tax strategies guide.