Net Unrealized Appreciation (NUA): How to Turn Ordinary Income into Capital Gains
Net Unrealized Appreciation (NUA): How to Turn Ordinary Income into Capital Gains
EXECUTIVE SUMMARY
- The Opportunity: If you hold highly appreciated company stock inside your 401(k), rolling it over to an IRA is usually a mistake. An IRA converts all future withdrawals into high-tax Ordinary Income (up to 37%).
- The Mechanism: The NUA Strategy allows you to distribute the stock “in-kind” to a taxable brokerage account. You pay Ordinary Income tax only on the original cost basis. The growth (Appreciation) is taxed at the lower Long-Term Capital Gains rate (0%, 15%, or 20%).
- The Payoff: On a $1M stock position with a $100k basis, you save the spread between Ordinary Income tax and Capital Gains tax on $900k. That can be a $150,000+ tax savings instantly.
- Authority Baseline: This strategy is strictly governed by IRC ยง 402(e)(4), requiring a “Lump Sum Distribution” after a “Triggering Event” (Separation from Service, Age 59ยฝ, or Death).
Most retirees blindly follow the advice: “Roll everything to an IRA.” For executives with company stock, that advice is malpractice. It takes a low-tax asset (Capital Gain) and turns it into a high-tax asset (Ordinary Income). Net Unrealized Appreciation (NUA) is the IRS’s apology for double taxation. It preserves the capital gains character of your stock. According to Team BMT Analysis, this is the single most important exit decision for employees of Apple, Microsoft, Exxon, and other long-term stock growers. Source: Fidelity Viewpoints / Kitces Research
Scenario: You hold $1M of Company Stock in 401(k). Cost Basis: $200k. Profit: $800k.
- Option A (IRA Rollover): Move $1M to IRA.
Future Tax: When withdrawn, the full $1M is taxed as Ordinary Income (37%).
Total Tax Bill: $370,000. - Option B (NUA Strategy): Move stock to Brokerage.
Immediate Tax: Pay Ordinary Income tax on $200k Basis only (37% * $200k = $74k).
Future Tax: When sold, pay Capital Gains tax on $800k (20% * $800k = $160k).
Total Tax Bill: $234,000. - Verdict: You saved $136,000 by choosing the right box on the distribution form.
BMT Verdict: The NUA election is irrevocable. Once you roll the stock into an IRA, the NUA tax benefit is lost forever. If your company stock has appreciated more than 30-40% above its basis, the NUA election is mathematically superior to the IRA rollover in almost every tax bracket.
Tax Rate Arbitrage
| Income Type | Top Federal Rate | Applicable to NUA Portion? |
|---|---|---|
| Ordinary Income (IRA Withdrawal) | 37.0% | No |
| Long-Term Capital Gains (NUA Sale) | 20.0% | Yes |
*Chart Note: The NUA portion also avoids the 3.8% NIIT (Net Investment Income Tax) if the stock is held, but future growth after distribution is subject to it. The immediate arbitrage is purely on the rate spread (37% vs 20%).
“But I don’t want to pay the tax on the basis now!” That is a valid cash-flow concern, but a poor wealth decision. Paying $74k now to save $136k later is a 183% return on your tax dollars. Unless you are completely insolvent, borrow the money to pay the tax if you have to. The arbitrage is too large to ignore.
CRITICAL SCENARIO: The “Lump Sum” Trap
One mistake kills the strategy.
| Requirement | Definition |
|---|---|
| Everything Must Go | To qualify for NUA, the 401(k) must be completely emptied in a single tax year. You cannot leave 10% behind. |
| The Split | Company Stock -> Taxable Brokerage (In-Kind).
Mutual Funds/Cash -> IRA (Rollover). Both must happen by Dec 31 of the trigger year. |
Execution Protocol
Ask your plan administrator for the “Cost Basis” of your company shares. Compare it to the Market Value.
Rule of Thumb: If Market Value is > 2x Cost Basis, NUA is likely a winner.
You must have a “Triggering Event”: 1. Separation from Service (Quitting/Firing). 2. Reaching Age 59ยฝ. 3. Disability/Death. Without one of these, you cannot use NUA.
Instruct the custodian explicitly: “Distribute Company Stock In-Kind to my Taxable Account. Roll remaining assets to my Rollover IRA.”
Warning: If they sell the stock inside the 401(k) and send you cash, the NUA is gone.
This strategy applies only to “Company Stock” held inside a qualified plan. It does not apply to stock options (RSUs/ISOs) or stock bought in an ESPP.
WEALTH STRATEGY DIRECTIVE
- Do This: Use NUA if you plan to sell the stock soon to diversify. It allows you to exit the concentrated position at a 20% tax rate instead of 37%.
- Avoid This: Doing NUA on 100% of your stock if you don’t need the cash. You can “Cherry Pick” the lowest basis shares for NUA and roll the high-basis shares to the IRA. (Ask if your plan allows partial share selection).
Frequently Asked Questions
Does the 10% penalty apply?
If you are under 59ยฝ (and left the job before age 55), the 10% penalty applies to the Cost Basis portion only. The NUA portion is exempt from the 10% penalty. This is a huge hidden benefit.
What about State Taxes?
Most states conform to federal NUA rules, taxing the basis as income and NUA as capital gains. However, check your specific state laws as some decoupled states may differ.
Do I get a step-up in basis?
No. NUA stock does not get a step-up in basis for the NUA portion upon death. The NUA is “Income in Respect of a Decedent” (IRD). However, any appreciation after the distribution does get a step-up.