Net Unrealized Appreciation Rules

I’ll never forget the conference call I had with a client that was getting ready to retire from the company she had worked for 20 plus years. She had saved as much as life had allowed her to and most was invested in the stock of the company that employed her all that time.

Almost Pulled The Trigger….

We were ready to give the instructions to do a 401k Rollover right before we learned that her cost basis in the stock was very low and she had a NUA (Net Unrealized Appreciation) opportunity to consider.

Upon learning that, we put it on hold and I had the luxury of trying to explain what Net Unrealized Appreciation rules were over the phone. If you don’t know, explaining NUA rules over the phone is not the wisest decision.

Without the support of really snazzy flow charts, makes it very difficult.

What is Net Unrealized Appreciation Anyhow?

What is this NUA already you ask? NUA is a favorable tax treatment on employer securities for lump-sum distributions from a qualified plan. More and more companies are offering employer stock as an investment option inside their qualified plans, allowing NUA to provide a potentially lower tax bill.

IRC 402 allows employees to take a lump-sum distribution of their qualified plan, pay ordinary income tax on the cost basis and then long-term capital gains on the growth, even if they sell it the same day. Does this sound too good to be true?

Qualifications For NUA To Work:

  1. Employee must take a lump-sum distribution.
  2. Employee may be subject to 10% penalty for premature distribution if under age 59 ½, unless the employee meets an exception to the premature distribution penalty under section 72(t).
  3. The cost basis is the FMV (Fair Market Value) of the stock at time of purchase regardless of whether the employer or employee contributed the money.
  4. NUA does not receive a step-up in basis upon death.  It is treated as income in respect of a decedent.
  5. If there is any additional gain above the NUA, the long-term/short-term capital gains will be decided looking at the holding period after distribution.
  6. No Required Minimum Distributions.

NUA Example

Bob had 500 shares of company stock in his 401k with a basis of $10/share.  He took a lump-sum distribution at retirement in January 2006.  The stock’s FMV was $20/share.  Bob sold the stock in February 2007 at a FMV of $25/share.  Bob recognizes ordinary income in the year of the distribution on the $10/share basis, which is $5,000.  In the year of the stock sale, he then recognizes $5,000 of long-term capital gains ($20/share at distribution less the $10/share basis) and also $2,500 of long-term capital gains on the gain since the distribution ($25 FMV – $20/share at distribution).  Had Bob not held the stock for one year after the distribution, the $5/share gain since distribution would have been short-term capital gains.

Is taking advantage of Net Unrealized Appreciation worth it?

The main consideration when exploring NUA is the ability for the employee to pay income tax on the basis of the stock in the year of distribution.  If the employee has considerable gains in the stock, NUA may be a viable option to pay lower taxes on the sale of the stock. Rolling over the qualified plan does allow the employee to defer taxes to a later date, but at the expense of missing the opportunity NUA offers to have some of the income taxed as long-term capital gains. Without NUA, the entire amount will be taxed on distribution as ordinary income.  What that equates to is a whole lot of tax that you did not have to pay.

Here’s another idea for planning exploration:

If the employee has large gains in employer stock, take a lump-sum distribution, roll-over the non-stock assets from the qualified plan to an IRA, and take the employer stock asset under NUA.  This treatment will defer taxes of already ordinary income assets and allow the employee to experience favorable long-term capital gains rates on the appreciated stock.


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Comments | 2 Responses

  1. Bettye Wallace says

    I appreciate you providing this information I have been going around and around with an issue related to a 401k transfer to an IRA. Once I did this with a firm I was left with questions on how to direct my funds. They could not direct me, and that left a really bad taste with me. This was most helpful. Investment firms talk to women as if they are completely simple. Thank You!!!

  2. Jim Munchbach says

    Hi Jeff —

    Just finished reading this excellent article on that unrealized appreciation. Now that I’m working at Morgan Stanley, I’m finding these kinds of transactions are more typical.

    After reading this article, I realized I was reading your article!

    Nicely done, my brother from another mother!

    See you at FinCon15!

    Jim Munchbach Just finished reading this excellent article on net unrealized appreciation. Now that I’m working at Morgan Stanley, I’m finding these kinds of transactions are more typical.

    After reading this article, I realized I was reading your article!

    Nicely done, my brother from another mother!

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