Company stock in a 401(k): the net unrealized appreciation rule in brief

Some 401(k) plans let employees hold shares of the company they work for. When that stock has grown in value inside the plan, the tax code offers a special way to take it out. The rule is called net unrealized appreciation, or NUA. It applies to a fairly narrow group of people, but for them the choice has to be made before any rollover happens, because a rollover to an IRA closes the door.

What NUA is

IRS Publication 575 defines NUA as the net increase in the value of employer securities while they were in the plan's trust. In plain terms, it is the difference between what the plan paid for the shares (the cost basis) and what they are worth on the day they are distributed.

Ordinarily, everything that comes out of a pre-tax 401(k) is taxed as ordinary income, whenever it is withdrawn. The NUA rule creates an exception. Publication 575 summarizes it this way: the employer stock basis is taxed as ordinary income, and the appreciation is taxed later at capital gains rates.

How the tax treatment works

When employer stock is distributed from the plan as actual shares, rather than being sold or rolled over, three layers of tax treatment apply.

1. Cost basis. The plan's cost basis in the shares is taxable as ordinary income in the year of the distribution.
2. The NUA. According to IRS Topic no. 412, the NUA is generally not subject to tax until the securities are sold. Publication 575 adds that when they are sold, any gain is long-term capital gain up to the amount of the NUA.
3. Growth after the distribution. Any gain beyond the NUA is long-term or short-term depending on how long the shares were held after leaving the plan.

The plan reports the NUA amount in box 6 of the Form 1099-R it issues for the distribution.

When the rule applies

Full NUA treatment depends on the stock being part of a lump-sum distribution. The IRS defines that as the distribution or payment, within a single tax year, of a participant's entire balance from all of the employer's qualified plans of one kind. It must also be paid for one of these reasons:

• because of the participant's death,
• after the participant reaches age 59½,
• because the participant, if an employee, separates from service, or
• after the participant, if self-employed, becomes totally and permanently disabled.

If the distribution is not a lump-sum distribution, Publication 575 states that tax is deferred only on the NUA resulting from employee contributions, which is a much narrower benefit.

Emptying the account does not mean everything has to be taxed. A common arrangement is to have the employer shares distributed in kind to a regular taxable brokerage account while the rest of the 401(k) is rolled directly to an IRA or another plan. The non-stock portion stays tax-deferred.

A hypothetical example

Suppose someone leaves a company at age 60 with a 401(k) that includes employer shares worth $100,000. The plan's cost basis in those shares is $20,000, so the NUA is $80,000. The figures are round numbers for illustration only.

Using NUA treatment. The shares are distributed in kind as part of a lump-sum distribution.

• $20,000 is ordinary income in the year of distribution.
• The $80,000 of NUA is not taxed until the shares are sold, and is then long-term capital gain. See how retirement income is taxed for how the two kinds of income differ.
• If the shares are later sold for $110,000, the extra $10,000 is long-term or short-term gain depending on how long they were held after distribution.

Rolling the shares into an IRA instead. No tax is due at the time of the rollover. Every dollar later withdrawn from the IRA, including the amount that would have been NUA, is ordinary income.

Which path results in less tax depends on the person's ordinary income tax rate, the capital gains rate that would apply, the size of the cost basis relative to the share value, and how long the money would otherwise stay tax-deferred.

Tradeoffs and limits

NUA treatment is not automatically favorable. Several things work against it in particular cases.

• Tax is due now on the basis. The cost basis is taxed in the year of distribution. When the basis is a large share of the stock's value, the upfront tax may outweigh the later benefit.
• The early distribution tax may apply. For someone under age 59½, the taxable part of the distribution may be subject to the 10% additional tax unless an exception applies, such as separation from service after reaching age 55. The exceptions are listed in IRS Topic no. 558.
• Concentration risk. Holding a large position in one company, especially an employer or former employer, ties both savings and paycheck to the same business. The SEC's investor education site describes diversification as spreading money among various investments so that losses in one may be offset by others. A tax rule is one factor in deciding whether to keep a single stock, not the only one.
• It cannot be undone by rollover. Topic no. 412 notes that after a rollover, the regular IRA distribution rules apply to later distributions and the special lump-sum rules are not available. Once the shares are in an IRA, the NUA option is gone.

Questions to ask the plan

Before any distribution or rollover from a plan that holds employer stock, a few facts are worth getting from the plan administrator:

• What is the plan's cost basis in the employer shares?
• Can the shares be distributed in kind?
• How will the plan report the distribution on Form 1099-R?

The rules for lump-sum distributions are detailed and the consequences of a misstep are hard to reverse, so individual tax situations vary and a tax professional can advise on the specifics. For the general mechanics of moving the rest of an account, see how a 401(k) rollover works and common rollover mistakes.