The Net Unrealized Appreciation (NUA) rule is a rarely used, but potentially meaningful, tax strategy for people who hold employer stock inside their 401(k). While not appropriate for every situation, understanding how NUA works may help certain retirees manage lifetime taxes and increase flexibility in retirement.
How The NUA Rule Works
Many employees accumulate company stock in their 401(k) over the course of a career. When that stock has appreciated significantly, the NUA rule offers an alternative to simply rolling the entire account into an IRA at retirement.
Under IRS Notice 98-24 and IRS Topic 412, the cost basis—what the stock was originally worth when it entered the 401(k)—is taxed as ordinary income when distributed. The appreciation—known as net unrealized appreciation—is not taxed at distribution. Instead, it becomes taxable as a long-term capital gain when the stock is eventually sold.
This structure creates a potential tax advantage: instead of paying ordinary income tax on the entire value of the stock (as would happen if rolled into an IRA and later withdrawn), the individual pays ordinary income tax only on the cost basis. The remaining growth is generally taxed at long-term capital gains rates, which may be lower than their ordinary income tax rate depending on the individual’s income and tax bracket.
Hypothetical Scenario: The $500,000 Stock Example
Consider the following hypothetical scenario for illustration purposes only.
A retiring employee holds employer stock in their 401(k) worth $500,000 today. The cost basis—the amount originally paid or contributed—is $100,000. If the retiree rolled the full amount into an IRA and later withdrew it, the entire $500,000 would eventually be taxed as ordinary income. Assuming a 25% ordinary income tax rate, that could result in $125,000 of taxes over time.
With the NUA approach, only the $100,000 cost basis is taxed at ordinary income rates at the time of distribution (again, 25% in this hypothetical), resulting in a $25,000 tax bill initially. The remaining $400,000 of appreciation is taxed later at long-term capital gains rates when sold—assume a 15% rate—which would be $60,000.
In this hypothetical, total lifetime taxes would equal $85,000 instead of $125,000. Of course, actual results depend on an individual’s tax bracket, timing, and future investment decisions.
Additional Potential Benefits of the NUA Strategy
1. Smaller Future Required Minimum Distributions (RMDs)
Moving company stock out of the IRA reduces the future IRA balance. A smaller IRA may result in smaller RMDs, which can help individuals manage taxable income later in retirement. (For those already subject to RMDs, the year’s RMD must be satisfied first and cannot be included in the portion using NUA.)
2. Increased After-Tax Flexibility
Once the employer stock is moved into a taxable brokerage account, it becomes subject to standard capital gains rules. For some retirees, this provides greater flexibility and fewer restrictions compared to IRA withdrawals.
When The NUA Rule May Make Sense
This strategy tends to be most beneficial when the following conditions apply:
- The employer stock has substantial appreciation relative to its cost basis.
- The investor is currently in a higher ordinary income tax bracket than the long-term capital gains bracket they expect to be in.
- The investor is comfortable holding the stock in a brokerage account and does not intend to immediately sell all the shares.
- A lump-sum distribution is feasible. NUA applies only when the entire vested balance from all of that employer’s qualified plans of the same type is distributed in one tax year after a triggering event, as outlined in IRC §402(e)(4) and IRS Topic No. 412. The employer stock must be taken in-kind, while the rest of the plan’s assets can be rolled into an IRA that same year. Under IRS Publication 575 and IRS Notice 98-24, the stock’s cost basis is treated as ordinary income, and the appreciation—the NUA—is taxed as a long-term capital gain when the shares are sold, while any additional growth after distribution is taxed under normal capital-gains holding-period rules.
If the cost basis is close to the current value, there is little difference between ordinary income taxes and capital gains taxes—making NUA less advantageous.
Bottom Line
Many retirees are unaware that the NUA rule exists, and a large number simply roll their 401(k) into an IRA at retirement—ending any possibility of using the NUA rule. While NUA won’t be right for everyone, understanding the rules before making major rollover decisions may help certain individuals reduce taxes and improve financial flexibility in retirement.
Those with employer stock in their 401(k) may want to review the NUA rules carefully and discuss the potential implications with a financial advisor and CPA to determine whether this strategy fits into their broader retirement plan.