Net unrealized appreciation, or NUA, is a special way of withdrawing your employer's stock from your employer-sponsored retirement account. Although the rules are somewhat complicated, NUA treatment could help you save a big chunk of money in retirement.
NUA is simply the difference between the cost basis of the employer stock in your employer-sponsored plan and the current market value -- assuming the market value is higher than that cost basis. For instance, if you retire with $1 million in your employer's stock in your employer-sponsored retirement account, and those shares have a cost basis of $250,000, you have $750,000 in net unrealized appreciation.
You can take advantage of NUA treatment to save a bundle of money on your retirement distribution if you meet each of the following three requirements:
- You own shares of your employer's stock inside your employer-sponsored retirement plan.
- Those shares are worth more than you paid for them.
- You withdraw them from your account via an in-kind lump-sum distribution.
Note: In many cases, you'll have to completely drain your employer-sponsored retirement plan as part of the transaction.
How NUA differs from a typical retirement withdrawal
In a traditional defined-contribution retirement plan, you and/or your employer contribute money to your account on your behalf using pre-tax dollars. While it remains in that account, the money compounds tax-deferred. Once you retire, you can start withdrawing money from that plan, paying ordinary income tax rates on the money you withdraw.
Have lots of highly appreciated employer stock in your 401(k)? Then a NUA strategy might make sense for you.
In a properly executed NUA transaction, however, the taxes are handled differently. Imagine that your company-sponsored retirement plan consists of $1 million of your employer's stock when you reach retirement and that you and/or your employer paid $250,000 for those shares.
If you take that $1 million as an in-kind, lump-sum distribution from your account and it qualifies for NUA treatment, you'll only pay income taxes on the $250,000 basis. To be an "in-kind" distribution, you need to take the shares out as shares of your employer's stock -- not converted to cash. To be a "lump sum" distribution, it needs to empty your employer-sponsored retirement account entirely.
The other $750,000 would remain untaxed until you sold the shares. Then the sale would be treated as a capital gain or loss. Your holding period would begin the day you took the distribution, and your basis for determining gains or losses would be the $250,000 you had already paid taxes on.
Capital gains taxes on short-term assets are typically the same as your ordinary income tax rates. In an NUA transaction, however, you get long-term capital gains treatment on the amount of the NUA as of the day you take the withdrawal, and only any appreciation above that level may be subject to the short-term capital gains taxes. If you hold those shares for at least a year and a day after you take your distribution, even that portion qualifies as a long-term capital gain and will be taxed at that lower rate.
Once you take the distribution, any dividends those shares pay become taxable, but if the company's dividends are qualified, you become eligible for the lower tax rate on qualified dividends. The table below showcases the tax savings you get from qualified dividends and long-term capital gains tax treatment.
| Marginal Income Tax Rate | Non-Qualified Dividends Tax Rate | Qualified Dividends Tax Rate | Short-Term Capital Gains Tax Rate | Long-Term Capital Gains Tax Rate |
|---|---|---|---|---|
| 10% | 10% | 0% | 10% | 0% |
| 15% | 15% | 0% | 15% | 0% |
| 25% | 25% | 15% | 25% | 15% |
| 35% | 35% | 15% | 35% | 15% |
| 39.6% | 39.6% | 20% | 39.6% | 20% |
Source: IRS Publication 550.
The pros and cons of NUA
The biggest plus of NUA treatment is the potential to pay substantially lower taxes on your retirement plan distributions. Not only could you pay long-term capital gains tax on money that's typically treated as ordinary income, but you may also get to defer paying those taxes even longer, too; once you take the NUA distribution, that money is no longer subject to the required minimum distributions that normally kick in at age 70-1/2 for traditional retirement plans.
Unfortunately, planning to receive NUA treatment comes with substantial downside risks as well. Most of those risks center around the fact that NUA treatment only works with employer's stock coming from your employer-sponsored retirement plan, which makes it an incredibly non-diversified strategy.
For NUA to make sense for you, you need a significant amount of your employer's stock, and it needs to be worth far more than it cost in the first place. On top of that, because a NUA transaction requires you to take money out of your employer-sponsored retirement account, you lose the ability to roll it into a traditional or Roth IRA and keep it tax-deferred.
Is NUA right for you?
Using an NUA-based retirement withdrawal strategy may make sense for you if all of the following are true:
- You have a substantial amount of highly appreciated employer stock in your employer-sponsored retirement plan.
- You firmly believe your employer's stock will hold its value long enough for you to sell it at a long-term capital gain and receive a much lower tax rate.
- You have sufficient investments in other assets to meet your retirement income needs in the case that your investment in your employer's stock somehow goes awry.
If not, you're likely better off following a more traditional retirement withdrawal strategy.
Editor's note: A previous version of this article included erroneous information on the capital-gains implications of net unrealized appreciation. The Fool and the author regret the error.
