Net Unrealized Appreciation (NUA) of Employer Stock
Withdrawals from tax-deferred retirement accounts are taxed as ordinary income, but special rules apply for holdings of employer stock with net unrealized appreciation. If the stock is distributed to the taxpayer as a lump-sum, then that stock can be rolled over to a taxable brokerage account instead of a traditional IRA, and the appreciation on the stock will be tax-deferred until it is sold. Although capital gains are taxed at ordinary tax rates in retirement accounts, any net unrealized appreciation (NUA) of the employer's stock can be taxed at the long-term capital gains rate when sold.
- NUA = Fair Market Value (FMV) of Stock when Distributed – Taxable Distribution Attributed to the Stock
- Taxable Distribution of the Stock = Employer's Cost + Employee's Cost for the Stock
When the stock is distributed in a lump sum, the original cost of the stock is taxed as ordinary income. Any appreciation of the stock above that cost until it is distributed is treated as NUA, which is taxed at the long-term capital gains rates when it is sold regardless of the holding period. Any appreciation beyond the fair market value (FMV) after the stock is distributed is taxed as long-term capital gains if the stock was held at least 1 year after the distribution; otherwise, the non-NUA appreciation is taxed as ordinary income.
To qualify for the NUA, all assets from all qualified plans of the former employer must be distributed, not just the ones containing shares of stock. The shares must be deposited in a taxable brokerage account, with the basis of the stock equal to what was paid for it, although the plan will determine both the tax basis and the resulting NUA. If a lump-sum payment is not made, then NUA treatment will only be available on shares that were bought with after-tax contributions.
For the NUA treatment, the following requirements must be satisfied:
- a triggering event occurred, such as separating from the employer, turning 59½, retirement, resigning, terminated, changing employers, total disability, or death
- the stock was bought with pre-tax contributions and employer matches; and
- the entire vested balance must be distributed as a lump sum within 1 tax year. Partial withdrawals may disqualify the plan from NUA treatment.
Example: you paid $10,000 for company stock with pre-tax earnings, which appreciated to $100,000, at which time it was distributed. The $90,000 of depreciation will be treated as NUA, and will not be taxed until it is sold. The $10,000 basis will be deemed a taxable distribution from the 401(k), subject to ordinary income tax rates. If the stock is sold at distribution, then it will be taxed as a long-term capital gain. If the stock is held, then any further gains will be taxed at capital gains rate depending on the holding period that begins when the stock was distributed. So, if the stock was held 1 year or longer, then the extra gain will be taxed at the long-term capital gains rate; otherwise, it will be taxed at the short-term capital gains rate. The $90,000 will still be taxed at the long-term capital gains rate, regardless of how the extra appreciation is taxed. So if you sold the stock for $120,000 6 months after receiving it, the $20,000 of extra appreciation will be taxed at ordinary income tax rates but the $90,000 NUA will still be taxed at the favorable long-term capital gains rate.
On the other hand, if the stock is rolled over into an IRA, then no tax will be due at the time of the rollover, but when it is sold, it will be taxed as ordinary income. It is permissible to rollover the non-NUA assets into another retirement account while distributing the company stock to a taxable brokerage account where it will receive NUA treatment.
The NUA will be listed on Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. from the 401(k) trustee, showing the basis in the NUA. The basis is taxed as ordinary income. If the taxpayer is younger than 55, then a 10% early withdrawal penalty tax will apply. Because NUA is income in respect of a decedent, the stock is not stepped up in basis upon the death of the taxpayer except for any appreciation above the NUA.
|Employer's Cost per Share||$100|
|Number of Shares||$10|
|Taxable Distribution||$1,000||= Employer's Cost / Share × # of Shares|
|FMV of Stock during Lump-Sum Distribution||$1,400|
|Non-Taxed NUA at Distribution||$400||= FMV – Taxable Distribution|
|Long-Term Capital Gain on NUA||$400||Regardless of Holding Period|
|Capital Gain on Non-NUA Appreciation||$200||Capital Gain Rate Depends on Holding Period.|
Because the shares are distributed in kind, there is no tax withholding on the distribution nor when the stock is sold, so withholding should be increased from employment sources or estimated tax should be paid to avoid possible penalties.
If the distribution is not a lump sum, then NUA treatment applies only to appreciation on the stock purchased by the employee. Both employer's contribution of shares and the appreciation thereof are taxed as ordinary income. Employer contributions will be listed on Form 1099-R.
|Average Cost of Shares||$1,000|
|Employee Contribution Percentage||55%|
|Employee Contribution||$550||= Average Share Cost × Employee Contribution %|
|FMV of Stock at Distribution||$1,900|
|Employer NUA||$405||= (FMV – Average Share Cost) × Employee Contribution %|
|Employee Taxable Income Due To Stock||$855||= Employer's Portion of Both Cost and NUA|
|Employee's Stock Basis||$1,405||= Employee Contribution + Reported Taxable Income|
If there is a loss on the stock when distributed, then the FMV at distribution is the taxpayer's stock basis. The loss cannot be claimed when the stock is distributed, but is claimed when the stock is sold for less than the stock basis.
|Total Contribution||$1,000||= Taxpayer + Employer Contributions|
|Stock Basis||$600||= Taxpayer Contribution|
|Capital Gain or Loss||($200)||= Sale Price – Stock Basis|
|Capital Gain or Loss||$100||= Sale Price – Stock Basis|
Whether the NUA treatment is desirable will depend on other factors, such as how long until retirement, and the percentage of basis out of the total value. Additionally, taking advantage of NUA will reduce IRA balances, thus lowering required minimum distributions. An election can be made to forgo the NUA treatment and include it as ordinary income, which may be advantageous if the capital gain is insubstantial and the taxpayer wants to accelerate the income, especially if the taxpayer wishes to claim averaging or capital gains treatment on Form 4972, Tax on Lump-Sum Distributions.