Net Unrealized Appreciation Treatment

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When your company stock is withdrawn from the account, you pay ordinary income tax only on the original cost of the stock.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 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that your entire 401(k) balance, including not only the stock, but also any other funds in the 401(k) plan, must be withdrawn in one year.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, although you could take it in cash, paying the tax on the withdrawal. 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 shares 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 (basis) of the stock. This means that you need to know what is the basis (the amount you originally paid) for the stock. Your company, 401(k) administrator, or custodian 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Although the entire account has to be withdrawn in a single year, you don’t have to elect NUA treatment for the entire holding of company stock.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 of the company stock is $100,000. You can move the company stock into a taxable investment account, and then you’ll pay ordinary income tax on $100,000, the basis. 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 long-term capital gains rate, which ranges from 0%, 15%, or 20% these days, much lower than the ordinary tax rate. (That capital gains rate is for long-term capital gains, and any stock that you elect NUA treatment for is taxed at that rate. The rate you pay is based on your other income, so if your income is low you’ll get by with the lowest rate, and so on.)

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* (see note below)

(The following is only a theory, I have not seen this implemented “in the wild”. See note below.) 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.

Note on the Basis Allocation Twist

I have not had a client do this, but (in my opinion, and seemingly that of others in the industry) the regs seem to allow it. The problem is that you have to get the 401(k) administrator to go along with coding the 1099R correctly, and no one wants to go out on a limb so far. Here’s a link to a followup article I wrote about this:

http://financialducksinarow.com/7711/nua-allocation-twist-not-as-easy-as-it-looks/

And this is my explanation of why I believe it should work:

Code section 402(c)(2) is where this comes from, where it is indicated that if a distribution is partially rolled over to an IRA, the rolled portion “shall be treated as consisting first of the portion of such distribution that is includible in gross income…”. Since basis in the NUA-eligible stock would be “includible in gross income”, the amount that is left behind in the QRP is everything except the basis (or the rolled portion was more than the basis), what remains can only be capital gains-treated.

The order of rollover needs to be into the IRA first, as the code section referenced specifically indicates the rolled portion “shall be treated as consisting first of the portion of such distribution that is includible in gross income…” – so you want to roll out (via direct transfer) the basis to be excluded from gross income over to the IRA first. Then whatever is left can go to the taxable brokerage account.

Also see Natalie Choate’s book “Life and Death Planning for Retirement Benefits”, 7th Edition, pp 178, 179 for additional discussion.

As a practical implementation matter, it is difficult and (so far) impossible to get the QRP administrator to code the 1099R appropriately – indicating the appropriately-taxable portion, due to lack of understanding and (likely) distrust of the system. For this reason the basis allocation in this fashion may not be available.