Net Unrealized Appreciate for Employee Stock Ownership

Net Unrealized Appreciation

An employee who owns company stock in their employer’s retirement plan will eventually have to decide how to distribute those assets—typically when you retire or change employers. Taking a distribution could leave the plan participant facing hefty taxes.  However, a tax break—taking advantage of  “net unrealized appreciation” (NUA)—can reduce ordinary income taxes.

On a lump-sum distribution including securities of a corporate employer, unrealized appreciation in the securities is excluded from the distributee’s gross income unless the distributee elects to forgo the exclusion. On other distributions, net unrealized appreciation in employer securities is excluded only to the extent attributable to employee contributions. Plan administrators must give notice of the exclusion of unrealized appreciation before making distributions, including employer securities.

The term “securities” includes stock and bonds and debentures with interest coupons or in registered form, and securities of a parent or subsidiary of an employer corporation are treated as securities of the employer. The “net unrealized appreciation” in such securities is the excess of their fair market value over the trust’s cost for them. A distributee’s adjusted basis for distributed securities is the securities’ fair market value, less the unrealized appreciation excluded from gross income. The excluded amount will be taxed as capital gain if the distributee subsequently sells the securities for a price not less than their value when distributed.

A “lump-sum distribution” is a payment within one taxable year of the entire amount becoming payable to a recipient

  • On account of the employee’s death;
  • After the employee attains age 59 1/2 ;
  • In the case of a common-law employee, on account of separation from the employer’s service; or
  • In the case of a self-employed person, after he or she has become disabled.

Defining NUA

NUA is the difference between the price the employee initially paid for a stock (its cost basis) and its current market value. Say you can buy company stock in your plan for $200 per share, and you use $20,000 to purchase 100 shares. Five years later, the shares are worth $350 each, for a total value of $35,000: $20,000 would be your cost basis, and $15,000 is your NUA.

When you want to distribute company stock or its cash value out of your 401(k), the employee has a couple of options

  1.  Roll it into an IRA (or another 401(k) plan),
  2.  or distribute the company stock into a taxable account and roll the remaining assets into an IRA or 401(k). 

The latter option might be more effective, depending on your circumstances, thanks to IRS rules governing NUA. When you transfer most asset types from a 401(k) plan to a taxable account, you pay income tax on their market value. But with company stock, you pay income tax only on the stock’s cost basis (not on the amount of its appreciation). ) Upon direct, in-kind transfer to an IRA, company stock’s unique NUA tax advantages are lost.

When you sell your shares, you’ll pay long-term capital gains tax on the stock’s NUA, along with any additional capital gains that occur after you make the distribution. The maximum federal capital gains tax rate is currently 20%, far lower than the current 37% top income tax rate, so your potential tax savings could be significant.

NUA Timing

Consider the following four factors as you decide whether to roll all your assets into an IRA or to transfer company stock separately into a taxable account:

Income Tax rates. The more significant the difference between the ordinary income tax rate and the long-term capital gains tax rate, the more significant the potential tax savings of electing an NUA tax treatment of company stock.

“Absolute” NUA. The larger the dollar value of the stock’s appreciation, the more the NUA rule can save you on taxes.

Percentage of NUA. An NUA with a higher percentage of total market value creates more significant potential tax savings because more of the proceeds will be taxed at the lower capital gains rate, and less will be taxed at income tax rates.

Time horizon to distribution. The longer you plan to keep your assets invested in an IRA or taxable account before liquidating them, the greater the potential benefit of tax-deferred growth, and therefore, the less you would benefit from NUA. A shorter time frame, on the other hand, makes the NUA election more attractive.

How NUA stock is typically taxed

Cost basisImmediately taxable as ordinary income when NUA distribution takes place after qualifying event (may be subject to 10% early withdrawal penalty)
NUA gainTaxable as long-term capital gains when company stock shares are sold
Post-distribution gainTaxed at short or longer-term capital gains rates based on the holding period from the distribution date

Example1: Utilize NUA and buy down the basis now to reduce taxes during retirement

Gary Schultz, age 67, recently retired with $2 million in his 401(k). He is widowed and currently in the 24% federal tax bracket. Fifty percent of Gary’s $2 million nest egg is company stock worth approximately $1 million. Because he participated in the company’s plan for 30 plus year years and purchased the stock at low share prices over time (the average basis vs. the current share price), his company stock’s actual cost basis is only $50,000.

Gary is still working, and his current salary is $100,000.  He made a $40,000 after-tax contribution to his 401(k) to buy down the basis of his company stock. Under his company’s retirement plan rules, he is allowed to use this money to reduce the baseline value on which taxes will be determined, allowing his taxable income to stay in the 24% federal tax bracket. If you have made after-tax contributions, that tax basis will automatically ascribe to anything you don’t directly roll over when you take the full payout, including the stock.

When Gary begins required minimum distributions (RMDs) within the next five years, he’s projected to be in the 22% federal tax bracket. To take advantage of NUA, after he retired this year, he requested a full distribution of his 401(k) account, sending the company stock in-kind to a taxable brokerage account and directly rolling over the rest to an IRA. Now, he’ll only pay tax at the ordinary income rate on $10,000 worth of the company stock, and he won’t be taxed on the gain on the company stock, valued at $1 million until he sells it. The other $1 million or so stays in the IRA to pay for future retirement expenses or give away to charities and family.

Senior man talking on phone and using tablet, sitting at desk at home. Modern technology, communication concept

Assuming he hasn’t yet sold the company stock at Gary’s demise, his heirs receive step-up in basis on it (under current law). Suppose the estate or inheritance tax is an issue. In that case, he could also consider transferring the company stock to an irrevocable trust as part of his estate planning strategy, working with a qualified estate planning attorney. 

Utilizing NUA
Value of company stock$2,000,000
NUA level$1,000,000
Original basis$50,000
After-tax contribution to 401(k) to buy down the basis of company stock$40,000
Taxable basis$10,000
Estimated tax bracket when investment gains are paid24% tax bracket
Estimated first year’s taxes$2,400
Estimated RMD amount at age 72, assuming 7% growth rate and no NUA election$112,000
Estimated RMD amount at age 72, assuming 7% growth rate and taking advantage of NUA$56,102
The difference in estimated yearly taxes vs. utilizing non-NUA approach starting at age 72$12,341*
Estimated tax bracket in retirement (assumes he takes advantage of NUA option) [1]22% tax bracket

Example 2: Mistake of Assuming Taxes are Lower in the Future

In some scenarios, however, income during retirement may be much lower than the current level and the effective ordinary income tax rate may be lower, so the investor may be better off skipping the NUA and merely rolling the company stock directly into an IRA.

In the following hypothetical scenario, consider Irving Utley, age 65. He’s had a long career in tech as an executive and earns about $500,000 a year, putting him in the estimated federal tax bracket of 35%.

Irving recently retired from one company with $2,500,000 in his 401(k) plan, of which $500,000 was invested in company stock. NUA is $250,000. Irving is at the peak of his earning capacity, loves what he does, and wants to work for another five years after leaving his current position and company this year.

Senior man talking on phone and using tablet, sitting at desk at home. Modern technology, communication concept

Irving would retire at age 70. Assuming all assets from his former employer’s 401(k) were rolled into an IRA, he would have projected annual income from his $170,000 investments and estimated RMDs of $154,000 at age 72. That should put him in the 24% federal tax bracket vs. his current tax bracket of 35%.

In Irving’s situation, if he exercised in Irving’s NUA, it would put him in a 37% bracket today and further increase the taxes to be paid on NUA. So, NUA doesn’t make sense, given his high level of current income, along with the anticipation that his tax bracket will likely be lower in the future.

Not utilizing NUA
Value of company stock$500,000
NUA level$250,000
Estimated tax bracket if not exercising NUA35%
Estimated tax bracket if exercising NUA37%
Estimated first-year taxes on NUA$92,500
Taxes on the same amount at age 72 at a 24% rate [2]$60,000

Technical Analysis

The cases and rulings generally agree that no separation from service occurs when an employer’s business is transferred in a reorganization or sale. The distributee becomes an employee of the transferee, even if the plan is terminated in connection with the transfer. 

Separation from service is a triggering event for common law employees because the concept’s meaning for self-employed persons is often ambiguous. The limitation of disability to self-employed individuals may reflect that common-law employees are ordinarily separate from service on disability. Attainment of age 59 1/2 was initially a triggering event for self-employed individuals (because of the irrelevance of separation from service to their circumstances). Still, common-law employees were subsequently added in the interest of equality. However, the distribution at age 59 1/2 to an employee who has not retired or otherwise separated from service may not be made by a pension plan because in-service distributions are considered inconsistent with such a plan’s nature. Plan termination is not a triggering event. A distribution can qualify as a lump sum only if it includes the entire “balance to the credit of an employee.” In applying this requirement, all employer pension plans are treated as one plan, and all profit-sharing programs are considered one plan, as are all stock bonus plans. A distribution of an employee’s entire interest under plans of one type (e.g., profit-sharing plans) may be a lump-sum distribution even if the employee has accrued benefits under plans of another type (e.g., pension plans) that remain undistributed. The definition of “lump-sum distribution” is “applied without regard to community property laws.”The “balance to the credit of an employee” includes any portion of the employee’s accrued benefit from the employee’s spouse under community property laws.[3]

On the other hand, if any portion of an employee’s entitlement is distributable to the employee’s spouse, former spouse, or dependent under a QDRO, this portion is excluded in determining the employee’s balance, allowing an employee to qualify for lump-sum treatment even if amounts of the vested accrued benefit are retained in the plan for subsequent payment under the QDRO. Conversely, a distribution to a spouse or former spouse under a QDRO may qualify as a lump-sum distribution if it includes the entire balance to the credit of the spouse or former spouse, and distribution to the employee at that time could qualify. A spouse or former spouse can be eligible even if the employee receives no contemporaneous distribution.

It generally makes sense to utilize NUA when you believe your current tax rate is the same or lower than what you expect it to be in the future. Consider the following three conditions, which may indicate that your income will not fall sharply in the future and may even rise:

Are you retired?
Are you taking RMDs?
Are you claiming Social Security benefits?

If yes is answered to all three conditions, an NUA may be to your advantage. However, it’s no guarantee, so be sure to consult with a tax advisor or financial planning professional regarding your situation before making any decisions.

“In general, it’s important to work out the various tax scenarios because you’ll eventually have to pay taxes on gains from selling company stock,” says Pomerance. “However, you don’t want to let taxes dictate investing decisions. Working with your Fidelity financial professional or on your own, make sure first to consider the sale of NUAs in light of your asset allocation, cash flow needs, and long-term retirement goals—then consult your tax advisor to determine if this tax strategy makes sense for you.”

The employee must meet all 4 of the following criteria to take advantage of the NUA rules:

You must distribute your entire vested balance in your plan within one tax year (though you don’t have to take all distributions).

You must distribute all assets from all qualified plans you hold with the employer, even if only one has company stock. It would be best if you took the distribution of company stock as actual shares.

You may not convert them to cash before the distribution.

You must have experienced one of the following:

Separation from service from the company whose plan holds the stock (except in the case of self-employed workers)
Reached age 59½
Total disability (for self-employed workers only)

[1]For hypothetical purposes only. State and local taxes not considered.  Calculation: ($112,200-$56,102) times 22% tax bracket = $12,341

[2]For illustrative purposes only. State and local taxes are not considered. Estimates are based on the subject filing taxes with the IRS as “married and filing jointly.” The estimated rate of growth on company stock: 6%

[3]”Taxation of Participants” Bittker & Lokken: Federal Taxation of Income, Estates, and Gifts