Net unrealized appreciation (NUA) is an option for handling company stock in a 401(k) plan when you leave the company.
What Is Net Unrealized Appreciation?
Net unrealized appreciation (NUA) is a rollover option for people to consider for their 401(k) dollars when leaving their employer. Under NUA, instead of rolling their entire account over to an IRA or to the plan of a new employer, they would treat the company shares and any other investments held in the account separately.
Using NUA would entail taking the company shares and distributing them to a taxable brokerage account in-kind. Any additional money in the 401(k) could still be rolled over to an IRA or to the plan of a new employer, if applicable.
Why Use NUA?
Normally the main benefit of rolling money from your 401(k) account over to an IRA or the plan of a new employer is the continued tax deferral for the money until withdrawn in retirement. At that point in time the money is taxed. This includes any company shares that were also rolled over. Your employer will be the source of the cost basis of these shares.
Under special rules for company shares, NUA allows you the option of distributing the shares to a taxable account. You would pay tax on the cost basis of the shares distributed in this fashion, not the current market value.
In a case where the stock price is highly appreciated over your cost basis for the shares, it might be advantageous to pay the tax on the cost basis now and then sell the shares at some point in the future and pay taxes on the capital gains at preferential capital gains tax rates. If you were to roll the shares over to an IRA, the value of the shares at the time that money was withdrawn would be taxed as ordinary income along with other withdrawals from the account.
An additional advantage for those whom using the NUA option makes sense is added diversification if the bulk of their assets are already held in tax-deferred retirement accounts.
If the stock’s current market value is not much higher than your overall cost basis in the shares, it may not make sense to use the NUA treatment on these shares, but rather it may be better to simply roll them over to an IRA with the rest of the assets in the account. Even if the shares have appreciated significantly in value over their cost basis, you will want to look at the tax impact of paying taxes on the cost basis of the shares in the tax year you are considering using NUA.
Specific NUA Rules
In order to qualify for this tax treatment under the NUA rules, there are a few rules that need to be understood and followed.
In order to take advantage of the NUA treatment for these shares, you must take a full distribution of all of the money in the account by the end of the calendar year in which you are considering using NUA. This means that all assets held in the account must be removed by rollover or withdrawal. In some cases, it might make sense to leave funds in the 401(k) of an old employer. This is not an option for those looking to use the NUA treatment on shares of company stock held in the plan. Generally NUA treatment must be after some triggering event like leaving the employer, turning age 59½, death or disability.
One aspect of using NUA that many are not aware of involves estate planning. Normally shares of stock held in a taxable account receive a step-up in basis when passed on to one’s heirs upon their death. With shares for which the NUA treatment was used, this option is not available. The heir’s cost basis would be the same as the owner had when the NUA distribution was made. This could result in the heirs incurring a larger capital gains tax bill when the shares are eventually sold.
What to Consider When Choosing NUA vs. an IRA Rollover
For those who have company stock in their 401(k) plan, NUA offers another option they can consider when leaving an employer and deciding how to handle the 401(k) account. Some things to consider:
- Can you afford to pay the tax on the taxable distribution of the shares in that tax year? Even though the ability to ultimately pay taxes on the capital gains from selling the shares at lower capital gains tax rates can be an advantage, you still have to be able to pay the taxes on the distribution in the current tax year.
- What is the outlook for the stock? While the future is unknowable, do you feel that the shares have a solid chance to appreciate in the future? The benefits of using the NUA treatment could be negated all or in part if the price of the shares decline after the in-kind distribution to your taxable account.
- If the shares of company represent a sizable concentrated position in your overall portfolio, it might make sense to roll some or all of the shares into an IRA and sell them inside the IRA, using the proceeds to improve your portfolio’s overall diversification.
- The time value of money between paying the taxes on NUA distribution on the cost basis now, plus paying the capital gains taxes at some point a year or more into the future, compared to the potential returns you could have earned on those funds if rolled over to an IRA and left to grow on a tax-deferred basis. There is no single right or wrong answer here. You will need to make some assumptions about the proper time frame until withdrawal and the appropriate discount rate (the rate of return you could have earned on the money if NUA wasn’t used) to use in analyzing the benefits of the tax treatment using NUA. This would be compared to having rolled the stock over with the rest of the money in the 401(k), withdrawing it at retirement and paying the tax on these funds in the future.