Net Unrealized Appreciation – Cut Taxes On Your 401(k) Stock

Introduction

Net Unrealized Appreciation or NUA is a retirement plan distribution strategy for those who hold highly appreciated company stock. Withdrawing 401(k) funds in this manner can result in significant tax savings versus the more common rollover method.

Utilizing the NUA strategy can allow for the company stock within a 401(k) to be taxed at long-term capital gains rates as opposed to ordinary income rates. Usually, all pre-tax funds within a 401(k) are taxed at the ordinary income rate when distributed from the account. However, with Net Unrealized Appreciation, the portion attributable to company stock can qualify for a significantly lower tax rate.

Employees with company stock in a workplace retirement plan should be aware of this approach and start preparing now. Evaluating whether this tax planning plan is appropriate for you can be complicated. Implementing it correctly is critical because there are pitfalls to avoid.

Reducing taxes in retirement is key. In this article, we will explore how NUA works, who it benefits, pros and cons, and common mistakes to avoid. We’ll also review an example comparing the NUA versus a typical rollover scenario.

What Is Net Unrealized Appreciation (NUA)?

Net Unrealized Appreciation is the difference in the cost basis and value of the employer stock held in a 401(k). The “unrealized appreciation” means the stock has not been sold. Its appreciated value has not been “realized.”

NUA is a strange name because it only describes the status of the stock rather than an action that is taking place. A better way to think of it is: You’re electing a 401(k) distribution method that treats the net unrealized appreciation of the stock with a more favorable tax rate.

Recap of 401(k) Rollovers

Before we dive too deep into NUA, we should revisit how 401(k) plans and rollovers typically work. When you participate in a 401(k), you’re putting your own dollars into the plan via salary deferral. Most of the time, this salary deferral is made pre-tax. Additionally, it is common for employers to contribute to the account as well. This can be in the form of employer matching, profit sharing, or both. These employer contributions are made pre-tax too.

Eventually, you’ll part ways with your employer. This might occur due to a job change, layoff, or retirement. When this occurs a common 401(k) distribution is known as a rollover. This allows a participant to move their funds from the 401(k) to their own Individual Retirement Account or IRA. This is done while preserving the pre-tax status of the funds. Stated another way, there are no taxes resulting from the rollover from 401(k) to IRA.

Recap of Tax Rates

When distributions are made from a 401(k), IRA, or any pre-tax retirement plan, the IRS considers those withdrawals taxable income. For example, if you pull $10,000 out of your IRA, the IRS sees $10,000 it needs to tax. The tax rate applied is based on ordinary income. Think 22%, 24%, or 32% for ordinary income tax rates depending on your income level.

Long-term capital gains rates, on the other hand, are significantly lower: 0%, 15%, and 20%. When the rates are written out this way, it doesn’t demonstrate how significant the difference is. Consider this: if you’re married filing jointly in 2025 and your income is less than $96,700 (includes the amount of realized gain), you can pay 0% on your long-term capital gains. If your income is between $96,701 and $600,050 your capital gains rate is only 15%. The difference is huge.

NUA Example

Let’s consider a 401(k) with $250,000 pre-tax total value. This is comprised of mutual funds and employer stock. The mutual funds represent $50,000. However, the employer stock appreciated significantly and is now worth $200,000. The basis in the stock is $30,000. That means there is $170,000 in net unrealized appreciation of the stock.

Scenario 1: Typical 401(k) Rollover

The 401(k) owner decides to rollover his retirement plan to an IRA as a typical rollover. They’re unaware of the Net Unrealized Appreciation option. The mutual funds and stock are sold and $250,000 is sent as cash to the new IRA custodian. The rollover process preserves the pre-tax status of the funds. No taxes result from the rollover as is normally the case. All is good. Or is it?

Because the rollover was completed in the typical way, 100% of the IRA funds will be subject to the higher ordinary income tax rates when the funds are used. This would be the case whether the IRA funds are distributed all at once or periodically over the life of the IRA owner.

Scenario 2: 401(k) Rollover with NUA Strategy

The 401(k) owner is aware of the NUA advantages in their situation. Upon leaving the company, the rollover process starts with the NUA election. Like the typical rollover process in Scenario 1, the mutual funds are sold and transferred as cash to the new IRA custodian without taxes. However, this is where things change.

Instead of the stock being sold, it’s transferred in-kind to a non-retirement brokerage account. The $30,000 basis of the stock becomes immediately taxable as ordinary income. However, the $170,000 of Net Unrealized Appreciation transfers to the brokerage account and won’t be taxed until it’s sold. When it is sold, it will be taxed at the lower long-term capital gains rates instead of the higher ordinary income rate.

Scenario Comparison and Assumptions

The illustration below compares three situations represented in the bar chart. For our purposes, we’ll focus on the two outer bars. And, to make the comparison a little easier to visualize, state income tax rates are omitted.

Additionally, after the rollover distribution all funds are disposed of at the end of the year (Final Distribution). While beneficial for easy comparison, fully distributing an IRA within a year of rolling over from the 401(k) is not a likely scenario. Despite this, it is good way to visualize the concept without over-complicating the explanation.

Scenario 1 (typical rollover method) results in a total tax bill of $48,000.

Scenario 2 (NUA strategy) results in a total tax bill of $32,700.

Taking advantage of the Net Unrealized Appreciation strategy saves $15,300 in taxes.

It’s important to remember that you won’t likely implement the plan as illustrated above. There are several other factors that must be included in the evaluation:

• How long you plan to hold the stock
• Expected return of the stock
• Tax rate when selling the stock and distributing from the IRA
• State tax rates
• Whether you have reached age 59 ½

NUA Eligibility & Requirements

As you can see, there is a compelling case for this tax planning strategy. Now that we’ve established what Net Unrealized Appreciation is and how it works, we must consider who is eligible and some key requirements. This is where things can get a little dicey. As you read on, remember the old expression “just because you CAN do something, it doesn’t mean you SHOULD.”

• Company Stock: You must own company stock within a company retirement account. Most often, this is within a 401(k). However, it can also be done with an Employee Stock Ownership Plan or ESOP. Phantom stock and stock options are not eligible.

• Triggering Event: These include separation of service, reaching age 59 ½, disability, or death. Obviously, you wouldn’t want the last option. However, it’s important to know that it’s still an option for a surviving spouse.

• Full Balance: You must rollover the entire vested account balance. Partial rollovers and transfers are not permitted.

• Timing: The NUA transaction must be completed within a single tax year. You will lose your eligibility if the process begins in one tax year and ends in another. Planning out the timeline for the distribution is key. For example, starting the process in December puts you at greater risk of not completing the transaction by the deadline.

Who Can Benefit from NUA?

The primary consideration for the NUA strategy is having a highly appreciated stock position. Remember, your basis in the stock is taxed at ordinary income rates. If your stock position isn’t highly appreciated, it means a large portion of the stock value is basis that won’t be eligible for the more favorable capital gains rates.

It should be noted that highly appreciated is subjective. There isn’t a specific amount of appreciation that indicates an ideal scenario. Instead, it is based on each person’s unique tax and financial situation at the time.  

Higher Income Tax Rate at Distribution

Let’s consider a scenario where someone expects to be in a higher income tax bracket when they will be taking distributions from their IRA. Paying ordinary income tax now on the basis versus later at a higher rate could be advantageous. Additionally, even if ordinary income tax rates are higher, it doesn’t mean long-term capital gains rates will be too. Refer to the comparison table of rates for Income Tax vs. Long-Term Capital Gains.

Taking Advantage of a Low-Income Tax Year

There are times when we find ourselves in a year when our income is lower and therefore in a much lower tax bracket. Think about a scenario where someone can be in the 0% LTCG category. If you’re married filing jointly and your income is less than $96,700 you’re in that range. Maybe your income is $50,000. If so, you could realize up to $46,000 of gains and pay $0 in long-term capital gains taxes. Zero!

Pros and Cons of the NUA Strategy

Pros:

• Potential for significant tax savings over traditional 401(k) rollover
• Diversification of concentrated stock positions
• Minimizing future Required Minimum Distributions or RMDs

Cons:

• Requires thorough analysis to determine if it’s advantageous for your situation
• Potential for significant tax increase in the year of distribution
• Complex rules for eligibility and implementation

Common Net Unrealized Appreciation Questions

Question 1: Do I have to sell the company shares within a certain period of time from the NUA?

Answer 1: No, once you’ve completed the NUA distribution, you a free to hold the shares for as long or short as you like.

Question 2: Do I have to sell all the shares at one time?

Answer 2: No, you can sell shares periodically when it’s the most ideal situation for you.

Question 3:  Can I do an NUA distribution if I’m under age 59 ½?

Answer 3: Yes, you can use Net Unrealized Appreciation if you are under age 59 ½ if there is a triggering event. However, you may still be subject to the IRS early withdrawal penalty of 10% on the cost basis. This is in addition to the ordinary income tax owed for the cost basis.

Question 4: Can NUA impact my Medicare premiums?

Answer 4: Yes, NUA can increase your taxable income due to income tax being applied to the cost basis of the stock shares. This increase in taxable income could result in higher Medicare premiums due to IRMAA surcharges.

Question 5: Will the shares I haven’t owned for more than a year be subject to short-term capital gains rates?

Answer 5: Unrealized gains from retirement plan will be taxable as long-term capital gains. This is the case even if the shares within the retirement plan were held for less than a year. However, subsequent gains beyond the distribution date will be taxed based on the holding period from the distribution date until the time of sale.

Common Mistakes To Avoid

• Failing to consider the risk of holding concentrated stock positions
• Misunderstanding how the basis is taxed at ordinary income rates which are higher than long-term capital gains
• Neglecting to follow the tax year deadline rule
• Partially rolling over the 401(k) balance
• Not seeking the guidance of a tax or financial professional

Coordinating Other Tax Planning Strategies

Despite the complexity and potential for significant tax savings, NUA is just one tax planning strategy. It won’t solve all the tax issues that warrant consideration before and during retirement. It is likely there will be other strategies requiring coordination with each other.

Other tax planning strategies like Roth conversions, Qualified Charitable Distributions (QCDs), and tax loss harvesting are just a few that can provide significant benefits. Coordinating these strategies is key to tax planning success.

Conclusion

Net Unrealized Appreciation is a powerful strategy. It can significantly reduce taxes and provide more options for how and when retirement funds are used. While there are pitfalls to avoid in the process, exploring this option is a worthy exercise. I would love to hear your thoughts and questions about Net unrealized Appreciation in the comment section.

Important Disclaimer

This Net Unrealized Appreciation article is for educational purposes only. It is not intended to be used as the sole basis for financial decisions. Bridgeview Capital Advisors, Inc. does not provide tax or legal advice and all individuals are encouraged to seek the guidance of qualified tax professionals prior to making any decisions about their personal situation. Taxable events may be irrevocable and may impact other facets of your overall finances.

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