Net Unrealized Appreciation

This often-misunderstood section of the IRS code can be quite a benefit – if it happens to fit your situation. Net Unrealized Appreciation (NUA) refers to the increase in value of your company’s stock held within your 401(k), either due to a company match or your own investment in the company stock within the 401(k). Other company-sponsored deferred accounts can apply here as well, but the primary type of account is the 401(k), so we’ll refer to all company-sponsored tax-deferred accounts as 401(k)’s for the purpose of this discussion.

In order to take advantage of the NUA provision, first of all you must hold your company’s stock in your 401(k), and you must be in a position to roll over the account. That is, you must have separated from service, by leaving employment (voluntarily or involuntarily), or the 401(k) plan is being terminated.

As you consider the rollover of your funds, if the company stock has increased in value, you have unrealized appreciation, that is, value that has not yet been realized due to a sale of the stock. The IRS allows for this appreciation to be treated as a capital gain, which can result in much lower tax rates on the gain.

In order to take advantage of this treatment, the 401(k) account must be rolled over in a one-time transaction, but there are a few things that you must do differently from other rollovers: The company stock will be rolled over into a taxable (non-IRA) account, while everything else will be rolled over into a traditional IRA.

When you roll over the company stock, this will be considered a distribution, but in this case there is no penalty on the early distribution (more on this in subsequent posts), however you will be required to pay the tax on the basis (or cost) of the stock. Your employer will have maintained records on your original cost of the stock.

As an example, let’s say you have participated in your company’s 401(k) plan for several years and are ready to retire. Part of the 401(k) funds have been invested over the years in your company’s stock, which has cost you a total of $10,000 through the years. Your company has done well, and now that stock is worth $150,000 in the market. If you rolled over this stock into an IRA, you would pay ordinary income tax on that growth of $140,000 – at whatever is your current marginal income tax rate (for example, let’s use 25%). Instead of going that route, you decide to use the NUA provision in the tax law to your advantage.

So, you set up a new IRA and a taxable account at the brokerage of your choice, and direct the 401(k) administrator to roll over your company stock to the taxable account, and all other funds to the IRA. When you roll over the company stock into the taxable account, you will be taxed (at ordinary income tax rates) on the basis of the stock – which, from our example, was $10,000. Now, not only will the growth of the stock ($140,000) have a tax rate of 15% (or less) for capital gains, you also do not have to take required minimum distributions (RMD) from those funds. You can leave the company stock in that taxable account forever if you wish, and hand it over to your heirs (who will receive a step-up in value to the current value of the stock at your passing).

Here’s the math: you pay tax at our example rate of 25% on the $10,000 basis of the stock, or $2,500. Then, as you sell some of the stock, the total amount of capital gains tax would be 15% (at today’s rates) of $140,000 (just the growth!) or $21,000. Compare that to the non-NUA treatment, where you might be taxed with ordinary income tax rates on the entire $150,000 stock value over time, for a total of $37,500! In this example, we’ve saved a total of $14,000 in taxes! Wow…

Now, NUA treatment doesn’t work for all situations. For example, if your company stock has only grown minimally in value, or has gone down in value, there is little or no benefit to utilizing the NUA option. Also, if the basis of the stock is fairly high relative to the growth, it might make sense to only apply NUA treatment to a portion of your company stock.

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Jim Blankenship, CFP®, EA, is an expert in personal retirement, IRAs, and tax issues, with more than 20 years of experience in the industry.  . Read more from this author