Net Unrealized Appreciation Treatment

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When you have a 401(k) plan that contains stock in your company, there is a special provision in the tax law that may be beneficial to you. This special provision is called Net Unrealized Appreciation, or NUA, treatment. It allows you to take advantage of potentially lower tax rates on the growth, or unrealized appreciation, of the stock in your company.

When your company stock is withdrawn from the account, you pay ordinary income tax only on the original cost of the stock. Then later when you sell the appreciated stock at a gain, you pay capital gains tax (at a lower rate) on the growth in the value of the stock.

The Way It Works

The distribution from your 401(k) must be a total Lump Sum Distribution in a single calendar year.  This means that your entire 401(k) balance, including not only the stock, but also any other funds in the 401(k) plan, must be withdrawn in one year.

Commonly the funds that are not company stock will be rolled over into an IRA or another 401(k) plan.  Only company stock (and only your company) can be treated with the NUA provision.

The company stock is moved into a taxable investment account – in kind.  This means that you move the actual stock rather than selling the stock and moving the money.  If you sell the stock before you move it, you won’t have NUA treatment available to you.

When you move the stock over from your 401(k) into a taxable account, you will have to pay ordinary income tax on the original cost of the stock.  This means that you need to know what is the basis (the amount you originally paid) for the stock.  Your company or 401(k) administrator will have this information for you.

Although the entire account has to be withdrawn in a single year, you don’t have to elect NUA treatment for the entire holding of company stock.  You could move only a portion of the stock if you choose to, and rollover the remaining stock to an IRA.  You may choose to do this because the amount of company stock is more than you care to pay ordinary income tax on during that tax year.  More on this a bit later.

An Example

For example, let’s say you have a 401(k) with a $500,000 balance.  $200,000 is invested in the stock of your company, and the basis is $100,000.  You can move the company stock into a taxable investment account, and pay ordinary income tax on $100,000.  If you’re in the 25% bracket, this would amount to $25,000.

The remaining $300,000 is rolled over to an IRA.  When you take money out of the IRA, as with any IRA, you’ll pay ordinary income tax on the money that you withdraw from the IRA.

At any point later you can sell the stock in the taxable account and pay tax at the capital gains rate, which is 15% these days, much lower than the ordinary tax rate. (That 15% rate is for long-term capital gains, and any stock that you elect NUA treatment for is taxed at that rate. This rate could be as low as 0% if you are otherwise in the 10% or 15% income tax bracket.)

Since paying tax on the entire $100,000 basis in your company stock would require a significant tax payment ($25,000 in our example), you might wish to work this out in a different fashion, reducing the tax.  Here’s where a twist to the tax code could REALLY be helpful – possibly eliminating taxation.

Basis Allocation Twist

When you move only a portion of the company stock, you need to allocate the basis between the NUA stock and that which was rolled over.  Since, in our example, the basis was $100,000 and the total company stock was worth $200,000, you could elect to rollover $100,000 worth of the stock to your IRA (along with the other $300,000 of funds), allocating the basis of $100,000 to the rolled over stock.  Then, when the remaining $100,000 of stock is moved from the 401(k) to the taxable account, there is no basis to be taxed at ordinary income tax rates.  The entire transaction has occurred without tax – and when you sell the stock, the entire value is taxed at capital gains rates.

This move is allowed because the tax law states that when there is a partial rollover of an account into an IRA, the rolled portion is “treated as consisting first of the portion that is includible in gross income” – meaning the basis in the stock, plus the other funds in the account.

So there you have it – Net Unrealized Appreciation in a nutshell.  If you need more details, you can check out the IRA Owner’s Manual for additional information.