Net Unrealized Appreciation (NUA)

Net unrealized appreciation is the difference between what an employer retirement plan paid for shares of the employer's own stock and what those shares are worth when they leave the plan. Internal Revenue Code section 402(e)(4)(B) makes it possible to keep that difference out of income at distribution: "in the case of any lump sum distribution which includes securities of the employer corporation, there shall be excluded from gross income the net unrealized appreciation attributable to that part of the distribution which consists of securities of the employer corporation." The plan's cost basis is ordinary income in the year of distribution; the appreciation is excluded then and taxed as long-term capital gain when the shares are eventually sold.

The value of the election is a rate arbitrage that only exists inside a retirement plan. Money that leaves a traditional 401(k) is ordinary income, at ordinary rates, forever. Employer stock distributed under this provision has most of its value converted to capital gain rates instead. The larger the gap between what the plan paid and what the shares are worth, the more the election is worth.

The mechanics of the split, and the holding-period quirk. At distribution, you include the plan's cost basis in the shares as ordinary income. The appreciation above that basis is excluded. When you sell, that excluded amount is long-term capital gain no matter how briefly you held the shares after the distribution, which is a genuine exception to the normal one-year rule. Any further appreciation after the distribution is a separate matter and follows the ordinary holding-period rules, so gain accrued in the first year after the distribution is short-term. Form 1099-R reports the net unrealized appreciation in box 6, which is the number to look for when the plan sends its paperwork.

What counts as employer securities. Section 402(e)(4)(E) restricts "securities" to "only shares of stock and bonds or debentures issued by a corporation with interest coupons or in registered form," and defines securities of the employer corporation to include securities of a parent or subsidiary. So this works for actual company shares, not for a fund holding them, and not for a company that is not a corporation. The shares also have to be distributed in kind. If the plan sells them and hands you cash, there is no appreciation left to exclude.

The all-or-nothing conditions, and the opt-out. The distribution has to qualify as a lump-sum distribution under section 402(e)(4)(D), which means the entire balance in that kind of plan paid within one taxable year on a qualifying event. Partial approaches exist in practice, because you can distribute the employer stock in kind while rolling the rest of the balance over, but the underlying distribution still has to meet the statutory test. Running in the other direction, the statute permits you to decline the treatment: a taxpayer "may elect, on the return of tax on which a lump sum distribution is required to be included, not to have this subparagraph apply." Publication 575 spells out the consequence of that election, which is that the full value of the securities is taxed as ordinary income and no portion qualifies for capital gain treatment under these rules. Declining is occasionally sensible, for instance where the basis is high relative to the appreciation.

A narrower version of the benefit survives even without a lump-sum distribution. Section 402(e)(4)(A) and Publication 575 both provide that where the distribution is not a lump-sum distribution, tax is still deferred on the appreciation attributable to the participant's own after-tax contributions, just not on the far larger share attributable to employer contributions. That matters only to someone who made after-tax contributions to the plan, which is why the election is usually described as all or nothing.

The 10% additional tax reaches only the taxable part. Someone under 59½ without an applicable exception owes the additional tax on the ordinary-income cost basis, not on the excluded appreciation. That makes the cost of an early election smaller than it first appears, though separating from service at 55 or later from a qualified plan is a common way the exposure disappears entirely.

The estate-planning trap, which is the most expensive thing on this page. Inherited assets ordinarily receive a step-up in basis to fair market value at death. Net unrealized appreciation does not. The appreciation embedded at the time of distribution is treated as income in respect of a decedent, so an heir inherits it and pays capital gain tax on it when the shares are sold. Only the appreciation that accrued after the distribution receives a step-up. Anyone applying the general step-up rule to inherited employer stock that came out under this election will reach the wrong answer, and the error is easy to make because the shares sit in an ordinary brokerage account looking like any other holding.

The unglamorous risk is concentration. The election rewards a large gap between basis and market value, and that gap is produced by holding a lot of one company's stock for a long time, often the company that also pays your salary. The tax result and the concentration risk grow from the same root, and the tax tail should not be what decides how much of one company you own.

The plan distributes the employer shares in kind into a taxable brokerage account, in the same year and as part of a distribution that satisfies the lump-sum test. The plan reports the cost basis as taxable and the appreciation in box 6 of Form 1099-R. You pay ordinary income tax on the basis for that year. The shares then sit in the brokerage account until you sell them, at which point the box 6 amount is long-term capital gain and anything beyond it follows normal holding-period rules.

A hypothetical example. Terrence retires at 62 with 4,000 shares of his employer's stock in his 401(k). The plan's cost basis is $18 a share and the stock trades at $95. His basis is 4,000 times $18, which is $72,000, and that amount is ordinary income in the year of distribution. The net unrealized appreciation is 4,000 times the $77 difference, which is $308,000, and it is excluded from income now. The two figures add to the full $380,000 market value, which is 4,000 times $95. Two years later he sells at $112. The $308,000 is long-term capital gain because the statute says so, and the additional 4,000 times $17, or $68,000, of post-distribution growth is also long-term because he held the shares more than a year. His total gain is $376,000, which is 4,000 times the $94 difference between $18 and $112, and it is all taxed at long-term rates.

The comparison that makes the election meaningful: had Terrence rolled the same shares into an IRA, the entire $380,000 plus every dollar of subsequent growth would eventually leave the IRA as ordinary income. Nothing in the account would ever be eligible for capital gain rates again.

Pros

• Converts the bulk of a pre-tax employer stock position from ordinary income to long-term capital gain, which is usually the largest single tax saving available in a workplace plan.
• The appreciation is long-term regardless of how long the shares are held after distribution.
• The 10% additional tax, where it applies, reaches only the ordinary-income basis rather than the whole value.
• Once the shares are in a taxable account, ordinary tax-loss harvesting and charitable-gift strategies become available to them.
• Diversifying afterward is a capital-gain decision rather than an ordinary income one.

Cons

• Tax is due in the year of distribution on the cost basis, in cash, whether or not any shares are sold.
• The requirements are strict and the mistake is permanent. Rolling the shares into an IRA cannot be undone.
• No step-up in basis at death on the embedded appreciation, so heirs inherit the gain.
• The election is only as valuable as the gap between basis and market value, and a high-basis position may be better off rolled over.
• The whole opportunity is a byproduct of holding a concentrated position in one company's stock, which carries risk the tax treatment does nothing to reduce.