What Is Net Unrealized Appreciation?

Some companies offer the benefit of employees owning stock in the employer company. The idea is that this creates an ownership mentality in the employees, even if they own a very small percentage of total shares. The net unrealized appreciation (NUA) is the difference in value between the average cost basis of shares of employer stock and the current market value of the shares. The NUA is important if you are distributing highly appreciated employer stock from your tax-deferred employer-sponsored retirement plan, such as a 401(k).

Key Takeaways

  • Net unrealized appreciation (NUA) is the difference between the original cost basis and current market value of shares of employer stock.
  • The IRS offers a provision that allows for a more favorable capital gains tax rate on the NUA of employer stock upon distribution, after certain qualifying events.
  • The downside is that ordinary income tax must be paid immediately on the cost basis of the shares of employer stock.

Understanding Net Unrealized Appreciation (NUA)

Typically, distributions from tax-deferred retirement accounts are treated as ordinary income at the time of distribution. Ordinary income is taxed at a higher rate than long-term capital gains. To remedy this issue, the Internal Revenue Service (IRS) offers an election for the NUA of employer stock to be taxed at the more favorable capital gains rate.

The NUA election is only available when the stock is placed into a tax-deferred account, such as a 401(k) or traditional IRA, and is only applicable to the stock of the company for which you are or were employed. Roth IRAs do not qualify for NUA because they are not tax-deferred, and brokerage accounts do not qualify for NUA because they are generally already subject to the capital gains tax.

Advantages and Disadvantages of Net Unrealized Appreciation (NUA)

Distributing stock out of a 401(k) will have different effects on NUA funds, per IRS rules and regulations. While the IRS will tax the majority of a 401(k) portfolio at its market value as ordinary income, shares of the employer stock will only be taxed as ordinary income on the cost basis. The cost basis is the original value of the employer stock. This means that any additional value gained since the stock was initially purchased is not taxed as ordinary income, and it will instead be taxed as capital gains. Upon selling the company stock, the NUA will be subject to the capital gains tax, which may be dramatically lower than your current income tax rate.

However, the downside is that ordinary income tax must be paid on the cost basis of the employer stock immediately. The trade-off is that ordinary income taxes would not have been due until you sold the shares in the future, years or decades from now. Because of this trade-off, it is best to only distribute the lowest cost basis shares under the NUA rules to optimize the tax consequences.

Requirements for Net Unrealized Appreciation

There are additional requirements that must be met as part of the NUA rules. Within one year, you must distribute the entirety of the vested balance held in the plan, including all assets from all of the accounts sponsored by the same employer. Certain qualifying events must also be met. You must have either separated from the company, reached the minimum retirement age for distribution, suffered an injury resulting in total disability, or you must have died.