The assets held in your 401(k) provided tax-deferred growth opportunities, but when you begin taking distributions, you will be paying ordinary income taxes. However, if you own shares of your company’s stock inside of their 401k plan that are valued higher than what you initially paid, you have what is called Net Unrealized Appreciation (NUA), and there is an opportunity to utilize a tax strategy to pay a lower rate when you ultimately sell them. But you must be careful to follow the strict rules imposed by the IRS.

To utilize the NUA tax strategy, you must first meet the following three guidelines:

  1. Experience a qualifying event (separation from service, attaining age 59½, or death)
  2. Employer stock shares must be distributed from the plan in kind.
  3. Lump-sum distribution.

The lump-sum distribution requires all the assets to be distributed from the employer plan in a single calendar year, bringing the account balance to $0. To receive the NUA tax benefit, the stock shares must be distributed to a brokerage (non-retirement) account, for which you will pay ordinary income taxes for the price you paid for the shares (cost basis), but not on the amount it gained since you bought it. When you decide to sell those shares, you will pay long-term capital gains rates on the stock’s NUA instead of ordinary income taxes.

NUA example

In the above example, Judy participates in a 401(k) plan and owns her employer’s publicly traded stock as a portion of the plan’s assets. She purchased 5,000 shares at $20 each in 2014, and today the stock is worth $45 per share. Judy is age 61 and is retiring this year, so she wants to utilize the NUA tax strategy. When she transfers the stock shares into a taxable brokerage account, she will pay ordinary income tax on the $100,000 cost basis in the same year that she transfers the shares. The $125,000 of growth, however, will be taxable at long-term capital gains rates when Judy or her heirs decide to sell the shares, as well as any additional appreciation realized after she makes the distribution. In our example, after the transfer to her taxable account, she immediately sells the shares, so she saved over $21,000 in taxes!

Summary of NUA Stock Taxation:

  • Cost Basis – Taxable as ordinary income when the distribution takes place after a qualifying event.
  • NUA gain – Taxable at long-term capital gains rates when the shares are sold.
  • Post-distribution gain – Follows same taxation as other taxable account assets.