What Is Net Unrealized Appreciation?

Definition and Examples of Net Unrealized Appreciation

Net unrealized appreciation is the difference between the cost basis of company stock and its fair market value when you take a distribution. That difference is taxed at capital gains rates, which are lower than income tax rates.

If you have company stock in a retirement plan, you can roll the plan assets over to an individual retirement account (IRA) when you retire from or leave your job. You also might be able to distribute the stock out of the plan and pay a lower tax rate on part of the money.

For instance, suppose you retire with 1,000 shares of your company's stock. You paid $10 per share, but now they're each worth $50. When you take a lump sum at retirement, the difference, or net unrealized appreciation, is $40 per share. That's the amount that can be taxed at capital gains rates.

• Acronym: NUA
  

How Net Unrealized Appreciation Works

When you leave at job at which you held a retirement account, you can either roll over the assets to an IRA or distribute the stock into a taxable account.

With the first option, any distributions you later take on the assets will be taxed at your ordinary income tax rate. This option might not be available, however. It depends on whether there are in-kind accounts that match your employee account. That is why many 401(k) plans liquidate the assets in your account and send a check or wire the funds in cash directly to your chosen IRA when you roll over funds.

The second approach, known as the "net unrealized appreciation strategy," may afford tax savings over the other approach. Under this strategy, you only pay ordinary income tax on the cost basis of the stock. You pay the lower capital gains tax rate on the rest of the distribution—and only when you sell the stock.

Suppose you have $60,000 of Widget stock in your 401(k). Think of your company stock as having three parts: cost basis, net unrealized appreciation, and additional appreciation.

Cost Basis

Cost basis is the price you paid for the shares. For instance, let's say that the cost basis of the total shares you own is $25,000. When you distribute the stock in kind as a lump sum upon retirement, you would pay tax on the cost basis at your ordinary income tax rate. This means that in the year of distribution, you would report $25,000 of income on your tax return as a pension distribution.

Net Unrealized Appreciation

If the total value on the day of distribution is $65,000, and your cost basis is $25,000, the NUA would be $40,000. Normally, you do not pay tax on this net unrealized gain until you sell the stock. At that time, it will be taxed at the long-term capital gains tax rate even if you sell it right away.

Additional Appreciation

"Additional appreciation" refers to capital gains earned after you distribute the stock if it continues to increase in price. This additional appreciation is taxed either at the short- or long-term capital gains rates. It depends on how long you hold the shares after they are distributed from the plan. You have to hold the shares for a minimum of one year to qualify for the lower long-term capital gains tax rates.

Requirements for Net Unrealized Appreciation

To qualify for the favorable tax rules of the NUA strategy, you must:

• Have employer securities in a qualified employer-based retirement account. These include company stock in a profit-sharing plan, stock bonus plan, or pension plan that your employer bought or you paid for with pretax dollars.
• Take a lump-sum distribution from a retirement account as a result of leaving your job or reaching age 59 1/2. A lump sum is a one-time distribution in one year of the entire balance of all qualified retirement accounts of a certain kind. Profit-sharing plans are one type of these plans. This can also apply if you're the beneficiary of a plan of someone who dies.
• Take a direct contribution of stock from the plan. In other words, don't roll over the stock to an IRA first and liquidate it. Move it directly into a taxable account.
  

What It Means for Individual Investors

Deciding whether the NUA strategy is the right one for you involves looking at a few factors.

Your Age

The younger you are, the more time there is for assets you roll over to an IRA to grow on a tax-deferred basis. If you have many years left before you retire, there's less benefit in taking the NUA tax treatment because the years of growth may outweigh the lower capital gains tax rates. The shorter your horizon, the more beneficial the NUA tax treatment is.

The Types of Retirement Accounts You Own

If the majority of your funds are in tax-deferred accounts, then distributing stock with NUA tax treatment may give you the chance to develop a balance between pretax and post-tax retirement assets. This may result in added tax savings when required minimum distributions (RMDs) begin. By lowering the amount of money in qualified retirement accounts, you will be lowering your RMDs.

The NUA Amount

If the cost basis is low, and the current value of company stock is high, the NUA will be high. That makes a larger share of distributions eligible for the lower capital gains tax rate.

Your Current and Future Tax Rates

If the ordinary income tax rate when you plan to take distributions from retirement accounts is projected to be quite a bit higher than long-term capital gains tax rates, the NUA strategy may be a better choice.

Your Risk

A sole stock in a brokerage account is a far riskier investment than a diversified portfolio. If one company's stock represents a large portion of your financial assets, and you plan on holding it long after distributing it from the plan, you must consider the investment risk. How does this work with your retirement goals?