Net unrealized appreciation (NUA) is a tax strategy that can allow you to shift a portion of your retirement account from income taxes to the special, much lower, capital gains tax rate. When successful, it significantly lowers the taxes you pay in retirement. To do this, you must have an employer-sponsored retirement plan that contains securities issued by your employer. Typically, this means that your employer contributed company stock to your account, but it can also apply to assets like bonds or related products. Under these circumstances, you may be able to switch some of your portfolio’s distributions from income taxes to capital gains. You may want to talk to a professional financial advisor before doing anything that could trigger a tax obligation.
What Is Net Unrealized Appreciation?
Under ordinary circumstances, when you take distributions from a pretax retirement account like a 401(k) the IRS taxes this money as ordinary income. This applies to both the original value of the assets, known as the “cost basis,” as well as their total gains, known as the “appreciation.”
For example, say that you put 1,000 shares of stock worth $10 each into your 401(k). Collectively they’re worth $10,000 at the time you get them, making that the stocks’ cost basis. Later, in retirement, those stocks have grown in value and are now worth $100,000. The $90,000 difference is their appreciation. When you sell those stocks the IRS will tax the full $100,000 at ordinary income rates.
Net unrealized appreciation is a tax strategy that allows you to shift some of those taxes from the higher income tax rates to the special, lower capital gains tax rates. It applies very specifically under the following circumstances:
- You must have an employer-sponsored retirement account
- The account must hold securities issued by this employer
- The account must be pretax, not a post-tax Roth account
- You must be a current or former employee of the employer
For ease of use, we will refer to 401(k) plans and company stock in this article. However net unrealized appreciation applies any time you can meet the factors above. So, for example, it can apply to company bonds or something like a pension plan. On the other hand, you cannot apply net unrealized appreciation to something like an IRA, even if you hold your employer’s stock in that account. Nor can you apply it to unrelated assets that you hold in a qualifying, employer-sponsored plan.
If you have qualifying employer assets, like stocks, in a qualifying plan, like a 401(k), you can arrange them to take net unrealized appreciation distributions. Under this tax approach, you would shift your employer stocks from your retirement account into a taxable brokerage account. The IRS would tax the stocks’ cost basis at the rate of ordinary income, but it would tax any future appreciation at the lower rate of capital gains.
Take our example above. Say that during your working life, your employer contributed 1,000 shares of stock worth $10 each into your 401(k). Those shares have now appreciated to $100,000. As discussed below, you can move those shares from your 401(k) to a taxable brokerage account. The IRS would charge you income tax on the $10,000 cost basis but would charge you capital gains taxes on the $90,000 appreciation.
How Do You Use Net Unrealized Appreciation?
Taking net unrealized appreciation is somewhat complicated. Here are the four things that you need to know about this happening and what you need to do.
1. A “Triggering Event” Must Occur
First, you must have what is called a “triggering event.” This means an event that allows or requires you to change the nature of your 401(k) or other employer-sponsored retirement plan. Most of the time this means leaving your employer, either because of retirement, termination or resignation. Death, qualifying disability or retirement eligibility (turning 59.5 years old) also apply.
2. Move Assets to Your 401(k)
Second, once the triggering event has occurred you must move the assets in your 401(k). Typically this means transferring your assets into a new employer-sponsored 401(k) or shifting them into an IRA if you have entered retirement and begun taking distributions.
This is important because a net unrealized appreciation must be taken all at once. You cannot parcel your shares out over time. Nor can you unring this bell. When you restructure a retirement portfolio after a triggering event, you must decide in that tax year to take any net unrealized appreciation that you want to claim and you must do so all at once.
3. Move Assets From Your Employer’s Plan
Third, you must move the assets from an employer-sponsored retirement account into a taxable portfolio. To claim the tax benefits of a net unrealized appreciation, you cannot move your assets from one tax-advantaged account into another. So, for example, you cannot roll these stocks over into a new 401(k) or an IRA. You must place them in an ordinary investment portfolio. As we wrote on the subject:
“Normally, when you want to take a distribution from a 401(k) plan that includes shares of company stock, you’d have a few options
- Rolling the entire distribution over to an IRA
- Rolling it over to a new 401(k) plan if you’re changing employers
- Separating company stock out into a taxable brokerage account and rolling the remaining account balance over to an IRA or new 401(k)
Net unrealized appreciation can be used if you choose the third option.” This can often mean separating assets from your retirement account. That can be particularly complicated if you hold company shares in something like a mutual fund. Yet, however, this transfer is ultimately structured, you cannot take an NUA on any company stock that remains in a tax-advantaged account nor can you gain tax advantages from assets unrelated to your employer.
4. Pay Income Taxes
Finally, you must pay income taxes on the assets that you move. When you move company stock from a retirement account into a taxable account, the IRS considers it a retirement account distribution. They will then tax you on the value of that distribution, applying it to your taxable income for the year in which you take that distribution. The point of net unrealized appreciation is that they will not tax you on the current market value of that distribution, though, just its cost basis.
For example, say that you want to take a net unrealized appreciation on the $100,000 worth of company stock in our example above. At retirement, you begin restructuring your 401(k) plan to take distributions from it.
You would take the 1,000 shares of stock in your former employer and move them to a taxable brokerage account that you have set up for this purpose. The IRS would consider this a distribution from your retirement account and would charge you income taxes on the value of that distribution. They would tax you on the cost basis of those stocks, so you would add $10,000 to your taxable income for the year.
Then, say you want to sell those stocks for cash. You would not pay anything on the stocks’ cost basis, because you’ve already paid those taxes. Instead, you would pay capital gains taxes on the $90,000 in appreciation.
Bottom Line
Net unrealized appreciation is a way of shifting some of your retirement portfolios from income taxes to capital gains taxes. It applies only to employer-sponsored, pretax retirement accounts and only to securities issued by the employer itself. However, if you qualify, it can save you real money on your taxes.
Retirement Tax Planning Tips
- It’s just as important to stay on top of your taxes in retirement as when you’re working. While there’s no one-size-fits-all answer out there, consider a few of these strategies when you’re making your own long-term plans.
- A financial advisor can help you build a comprehensive retirement plan. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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