Net Unrealized Appreciation (NUA) on Company Stock

If you hold employer company stock inside your 401(k), one obscure provision of the tax code can convert decades of growth from ordinary income into long-term capital gains. It is called Net Unrealized Appreciation, governed by IRC §402(e)(4), and it works exactly once: at distribution.

The mechanic

When you take a lump-sum distribution from your 401(k) and transfer the employer stock to a taxable brokerage account (not into an IRA), you pay ordinary income tax only on the stock's basis, the cost the plan paid to buy the shares for you. The NUA, the difference between basis and current market value, sits untaxed until you sell, at which point it is taxed as long-term capital gain regardless of how long the stock has been in the brokerage account.

The four conditions, all required

1. Lump-sum distribution. The entire vested balance of the plan must leave the plan within one tax year, as defined under §402(e)(4)(D).
2. Triggering event. Separation from service, reaching age 59½, death, or disability.
3. Employer stock, not other securities. Only stock of the employer that sponsors the plan qualifies.
4. Direct transfer to a taxable account, not a rollover. The stock goes "in kind" to your brokerage. Rolling it to an IRA destroys NUA permanently.

Worked example

An executive retires at 60 with a 401(k) containing $1,000,000 of employer stock. The cost basis (what the plan paid over decades) is $150,000. He takes a lump-sum distribution and transfers the stock to his taxable account.

• Year of distribution: ordinary income tax on the $150,000 basis. At a 32% bracket: $48,000 federal tax.
• $850,000 NUA sits in the brokerage account, untaxed.
• When he sells, the next day or ten years later, the $850,000 is taxed at long-term capital gain rates: 15% or 20%, plus the 3.8% NII tax above the thresholds. At 23.8%: $202,300.
• Total federal tax on the $1,000,000: approximately $250,000, or 25%.

If instead he had rolled the stock to an IRA, the entire $1,000,000 would eventually be taxed as ordinary income. At 32%, that is $320,000. NUA saved $70,000.

When NUA is the wrong call

NUA shines when basis is small relative to current value. If basis is 50% of value or more, the up-front ordinary-income hit on the basis often outweighs the rate-arbitrage savings on the NUA. The break-even depends on your ordinary rate, your capital-gains rate, your time horizon to sale, and the projected growth of the stock if it stays in tax deferral. Run the numbers: a spreadsheet beats intuition every time.

Common mistakes

• Rolling the stock to the IRA first, "to think about it." Once inside the IRA, NUA is dead. The decision must be made at distribution.
• Forgetting the lump-sum requirement. Taking a partial distribution in one year and the rest the next forfeits NUA on everything.
• Diversification risk. NUA only pays off if the stock is worth something later. Concentrated single-stock risk in retirement is real; the tax saving is no consolation if the stock falls 60%.
• Skipping the 10% early-distribution penalty analysis. If the triggering event is separation from service before age 55, the basis amount is subject to the 10% early-distribution tax under IRC §72(t).

Sources

• Internal Revenue Code §402(e)(4), Net Unrealized Appreciation (Cornell LII): law.cornell.edu/uscode/text/26/402
• Treasury Regulation §1.402(a)-1(b), employer securities treatment: law.cornell.edu/cfr/text/26/1.402(a)-1
• IRS Publication 575, Pension and Annuity Income, NUA discussion: irs.gov/forms-pubs/about-publication-575
• IRS Notice 89-25, lump-sum distribution definition: irs.gov/pub/irs-drop/n-89-25.pdf
• Internal Revenue Code §72(t), 10% early-distribution tax: law.cornell.edu/uscode/text/26/72

If you hold employer stock in a 401(k), tell RetirementCheck101 in step 3. NUA changes the math. Explore the free educational tool.