Net Unrealized Appreciation (NUA): How to Pay 20% Tax on Your 401(k) Instead of 37%
Net Unrealized Appreciation (NUA): How to Pay 20% Tax on Your 401(k) Instead of 37%
📜 WHO THIS IS FOR (Prerequisites)
- Required Profile: Corporate employees (or retirees) holding significant Company Stock inside their 401(k) plan.
- Primary Objective: Tax Rate Arbitrage (Converting Ordinary Income tax liability into Capital Gains tax liability).
- Disqualifying Factor: Investors whose company stock has a high cost basis (low appreciation) or those who have already rolled over the stock to an IRA.
⚠️ STRATEGY ELIGIBILITY CHECK
NUA rules are draconian. A single mistake disqualifies the entire tax benefit.
- ☑️ Trigger Event: Must have experienced Separation from Service, attained age 59½, disability, or death.
- ☑️ Lump Sum Rule: Must distribute the ENTIRE balance of the 401(k) within a single tax year. (You cannot leave $1 behind).
- ☑️ Asset Location: The stock must be held in kind. Do not sell the stock inside the 401(k) before distributing.
- ☑️ Basis Spread: The stock must have significant appreciation (Growth > Basis). If Growth is small, NUA is not worth the complexity.
*If you roll over the stock to an IRA first, the NUA option is lost forever.
EXECUTIVE SUMMARY
- The Default Trap: When you roll over a 401(k) to an IRA, all future withdrawals are taxed as Ordinary Income (up to 37%). You lose the preferential capital gains treatment on any stock growth.
- The NUA Strategy: Instead of an IRA rollover, you move the Company Stock directly to a Taxable Brokerage Account.
- The Mechanics:
1. You pay Ordinary Income Tax immediately only on the Cost Basis (the original purchase price).
2. The Appreciation (NUA) is transferred tax-deferred. When you eventually sell the stock, it is taxed at Long-Term Capital Gains rates (0%, 15%, or 20%). - The Payoff: On a $1M stock portfolio with a $100k basis, you trade a $370k potential tax bill (IRA withdrawal) for a ~$217k total tax bill (NUA route).
Most retirees blindly check the “Rollover to IRA” box. For those with highly appreciated company stock, this is a six-figure mistake. NUA is the IRS’s rare gift to employees who bet on their own company. However, it requires liquidity to pay the immediate tax on the basis. Source: Fidelity Executive Services / Kitces Research
- Scenario: $1,000,000 in Company Stock inside 401(k).
- Cost Basis: $100,000 (Average cost of shares bought years ago).
- Appreciation (NUA): $900,000.
- Tax Rates: Ordinary Income Tax = 37%. Long-Term Capital Gains Tax = 20% + 3.8% (NIIT).
- Comparison: Immediate liquidation value vs. Rollover & Withdrawal.
Tax Liability Comparison ($1M Stock)
| Strategy | Total Estimated Tax ($) | Effective Tax Rate (%) |
|---|---|---|
| Standard IRA Rollover (Ordinary Inc.) | 370000 | 37.0 |
| NUA Election (Basis@37% + Growth@23.8%) | 251200 | 25.1 |
*Chart Note: The NUA strategy saves ~$118,800 in taxes by shifting the $900k growth from the Ordinary Income bucket to the Capital Gains bucket. The lower the cost basis, the wider this gap becomes.
Tax Characterization Matrix (Asset Location)
*NUA fundamentally changes the “character” of the asset in the eyes of the IRS.
| Action | Cost Basis Treatment | Appreciation (Growth) Treatment |
|---|---|---|
| Rollover to IRA |
Deferred Taxed as Ordinary Income upon withdrawal (up to 37%). |
Deferred Taxed as Ordinary Income upon withdrawal (up to 37%). *Loss of LTCG Rate Preference. |
| NUA Distribution |
Immediate Tax Taxed as Ordinary Income in year of distribution. |
Tax Preferred Taxed as Long-Term Capital Gains (0/15/20%) when sold. *Never taxed as Ordinary Income. |
*Operational Note: The NUA strategy “locks in” the capital gains rate for the appreciation, regardless of future income tax hikes.
The Catch: To unlock NUA, you must pay tax on the Cost Basis now.
- Year 1 Action: Distribute the stock to a brokerage account.
IRS View: You earned $100k (the basis) as income.
Bill: You owe ~$37k in taxes this April. You need cash outside the 401(k) to pay this. - Future Action: Sell the stock instantly or hold it.
Upon Sale: The $900k gain is taxed at LTCG rates immediately. (NUA gain is always Long-Term, even if held for 1 day outside the plan).
⛔ BOUNDARY CLAUSE: Structural Limitations
- The “Lump Sum” Trap: If you rolled over part of your 401(k) last year and try to do NUA this year, you fail. The “Lump Sum” rule requires the entire balance to be distributed in one taxable year. A prior partial rollover may disqualify you.
- State Tax Drag: Some states do not recognize the federal NUA tax preference and tax the whole amount as ordinary income. Check state conformity (e.g., NY vs CA).
- Concentration Risk: Holding $1M in one stock is risky. NUA encourages holding the stock. If the stock crashes 50% after distribution, the tax savings are irrelevant. You must balance tax alpha vs. investment risk.
👤 DECISION BRANCH (Logic Tree)
IF Basis > 30% of Total Value:
• Input: Stock price hasn’t grown much (e.g., $1M Value, $800k Basis).
• Output: Skip NUA. Roll over to IRA. The small tax spread isn’t worth the immediate tax bill on the large basis.
IF Basis < 20% of Total Value:
• Input: Highly appreciated stock (e.g., $1M Value, $50k Basis).
• Output: Execute NUA. The immediate tax hit is small compared to the massive future savings.
NUA is a high-precision maneuver. It requires coordination between your payroll department, the 401(k) custodian, and your brokerage. One administrative error (like withholding tax from shares) can ruin the calculation.