If you’ve spent a career at a public company and your 401(k) is stuffed with employer stock, the standard advice, “roll it all into an IRA when you leave,” could cost you a six-figure tax break. There’s a rule buried in the tax code called Net Unrealized Appreciation, or NUA, and it lets you pay long-term capital gains rates on decades of stock growth instead of ordinary income tax.
Here’s the scenario that keeps CPAs up at night. A retiring engineer has $400,000 of company stock in his 401(k). His cost basis, meaning what the shares were worth when the plan bought them, is $50,000. The other $350,000 is pure appreciation. Roll the whole account into an IRA, and every dollar he later withdraws gets taxed as ordinary income, potentially at rates up to 37%. Use NUA instead, and that appreciation gets taxed at long-term capital gains rates, currently capped at 20%, when he sells.
The Rule Hiding in Section 402(e)(4)
NUA is authorized by Internal Revenue Code Section 402(e)(4). When you take a lump-sum distribution of employer securities from a qualified retirement plan, you pay ordinary income tax only on the cost basis of the shares at distribution. The appreciation, the NUA itself, is deferred until you sell, and it’s always taxed at long-term capital gains rates, regardless of how long you actually hold the stock after distribution.
That last part is the quiet miracle. Sell the stock the next day, and the growth still qualifies for LTCG treatment. Roll it into an IRA and you convert what would have been capital gains into ordinary income forever.
Who Can Actually Use This
NUA only works if you meet three conditions. You must hold actual employer securities inside a qualified plan like a 401(k) or ESOP. IRAs, 403(b)s, and 457(b)s are excluded. You need a triggering event: separation from service, reaching age 59½, death, or total disability. And you must take a lump-sum distribution, meaning the entire account balance across all plans of the same type from that employer, distributed within a single tax year.
If your 401(k) holds only mutual funds or target-date funds, there’s no NUA to unlock. This strategy rewards long-tenured employees at public companies where match contributions or ESOP allocations were paid in company stock that appreciated substantially.
How to Execute the Strategy
- Get a cost basis statement from your plan administrator. You need the basis on each lot of employer stock. A low basis relative to current market value is what makes NUA worth doing.
- On your triggering event, instruct the plan to transfer the company stock in-kind to a taxable brokerage account. Not an IRA.
- Roll the rest of the 401(k), the mutual funds, bonds, and non-employer holdings, into a traditional IRA in the same tax year. This preserves the lump-sum treatment.
- Report the cost basis as ordinary income on that year’s return. Your plan will issue a 1099-R showing the basis in Box 2a and the NUA in Box 6.
- When you sell the stock, report the NUA as long-term capital gain regardless of holding period. Any additional appreciation after distribution follows normal holding-period rules.
The Trap That Wipes Out the Break
The rule is unforgiving. Roll even one share of the employer stock into an IRA first, and you permanently lose NUA treatment on those shares. You can’t undo it. Same result if you take partial distributions across two tax years, or if you take a distribution before a qualifying triggering event.
The other catch: you owe ordinary income tax on the cost basis in the year of distribution, in cash, out of pocket. If you separate before age 55, there’s also a 10% early withdrawal penalty on that basis amount. That’s why NUA usually favors employees who retire at or after 55 with a low basis and highly appreciated stock. Run the numbers with a CPA before you sign the distribution paperwork. Once those shares hit an IRA, the six-figure break is gone for good.
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