What to Know About Net Unrealized Appreciation (NUA) Before Rolling Over Your 401(k)

As you approach retirement or move to a new employer, a 401(k) rollover probably feels like a natural next step on your to-do list. But if your retirement plan includes employer stock that has grown significantly over time, rolling everything into an IRA without a closer look could mean foregoing a powerful tax opportunity.

Called net unrealized appreciation (NUA), this lesser-known, but potentially valuable, strategy may be able to help reduce how much you pay in taxes on highly appreciated company stock across your lifetime. Before finalizing a rollover, take a look first at what NUA is and how it works.

What Is Net Unrealized Appreciation (NUA)?

NUA refers to the difference between what you paid for your employer stock (also known as its “cost basis”) and what that stock is worth today inside your employer-sponsored retirement plan, specifically your 401(k).

As a reminder, traditional 401(k)s are funded with pre-tax dollars and grow tax-deferred. Once you turn 59.5, you’ll be allowed to withdraw penalty-free from your retirement accounts. However, any withdrawals (including your original contributions and growth within the account) will be subject to your ordinary income tax rate.

For those approaching retirement, NUA may present an opportunity to achieve more favorable tax treatment during withdrawals.

When an NUA strategy is implemented properly, the account appreciation can be taxed at long-term capital gains rates, rather than at ordinary income tax rates, which can be significantly higher.

For example, let’s say you purchased employer stock within your 401(k) for $50,000 and it’s now worth $250,000. That $200,000 of appreciation is the “net unrealized appreciation.” With an NUA strategy, the $50,000 cost basis is taxed as ordinary income, but the $200,000 of growth can be taxed later on at long-term capital gains rates instead.

It’s important to note, NUA only applies to employer stock held inside a qualified retirement plan, such as a 401(k). It does not apply to stock purchased in a taxable account or held in an IRA.

A Reminder About Long-Term vs. Short-Term Capital Gains Tax

Why can achieving long-term capital gains tax treatment be so beneficial for retirees?

Wages, bonuses, typical 401(k) withdrawals, and other forms of “ordinary” income are taxed at rates up to 37% at the federal level, depending on your income. This same rate is applied to short-term capital gains, which refers to gains achieved from holding assets for less than a year.

Long-term capital gains tax is applicable, however, if the assets were held for at least one year prior to being sold for a profit. Long-term capital gains receive preferential tax treatment, with rates of either 0%, 15%, to 20%, depending on your total taxable income.

Depending on cost basis and gains, having the ability to leverage the long-term tax rates can yield substantial tax savings across your lifetime—particularly when large amounts of appreciated stock are involved.

How an NUA Strategy Works

An NUA strategy can help you separate what’s taxed immediately from what can be taxed later at the lower long-term capital gains tax rate. When executed effectively, creating this distinction in retirement income can help reduce your tax exposure throughout retirement.

Before we walk through how an NUA strategy works, we first want to note and define the term “in kind,” as it’s critical to the success of the strategy. An “in-kind” distribution means the actual shares of stock are transferred out of the account as stock. They are not sold and repurchased in a different retirement account. The shares cannot be liquidated inside the 401(k) when executing an NUA strategy.

To begin, you’ll take a lump-sum distribution of employer stock in kind from your 401(k), which can be placed into a taxable account. The cost basis of the shares becomes immediately taxable as ordinary income in the year you take the distribution. However, the unrealized appreciation (referring to the gain) is deferred until you sell your shares. Once the time does come to sell, the gains will be taxed at the long-term capital gains rate—which is likely lower than your ordinary income tax rate. If additional gains were earned in the account after rollover has occurred, they’ll be taxed as either short-term or long-term capital gains, depending on how long they were held before being sold.

An NUA strategy only works if the entire 401(k) is emptied. If you have other assets aside from employer stock in the plan (say, mutual funds, bonds, etc.), they can be rolled into an IRA without incurring tax.

Let’s take a look at how an NUA strategy might benefit a retiree with $750,000 in employee stock in his 401(k), assuming a 24% tax rate:

In this example, executing an NUA strategy provides the employee with a lifetime tax savings of around $58,500. (As a reminder, this is a simple example and may not take into account all factors impacting his tax liability.)

Who May Benefit from an NUA Strategy?

NUA only applies to 401(k) plans (or similar qualified plans) that contain employer stock. If your retirement account holds only mutual funds, ETFs, or other investments, the NUA rules simply don’t apply. 

If you hold a large amount of highly appreciated employer stock inside your 401(k), an NUA strategy can help make that large gap between the original cost basis and the current market value of that stock more tax-efficient to access. 

It can be particularly attractive for those in a higher tax bracket, where rolling the stock into an IRA and later withdrawing it as ordinary income could result in a much larger tax bill.

NUA may also make sense for investors who want to diversify their holdings gradually rather than sell employer stock all at once, since it allows them to manage capital gains over time.

Who Might Not?

That being said, there are situations where NUA may not be the right fit for someone with employer stock in their retirement plan. Particularly, if:

• The cost basis is already high or there’s very little appreciation.
• You plan on selling stock immediately after distribution, limiting the long-term capital gains advantage.
• You need the funds right away and can’t defer gains over time, meaning the upfront tax hit may outweigh the benefits.
• Your portfolio is already heavily concentrated in employer stock, and you’d rather focus on reducing risk than lowering lifetime taxes.

Thinking of Rolling Over Your 401(k)?

NUA can be a powerful tax strategy, but only if it’s considered before a 401(k) rollover is conducted. Once employer stock is rolled into an IRA, the NUA opportunity is typically no longer available.

If you have highly appreciated company stock in your retirement plan, pause and consider what may be the best move to make next. A thoughtful analysis can help determine whether NUA fits into your broader retirement, tax, and diversification strategy.

Before rolling over your 401(k), schedule a call to speak with our team first. We can help you understand the nuances of employer stock, retirement distributions, and tax planning—particularly when managing your highly appreciated employer stock.