Net Unrealized Appreciation in Company Stock

Natalie Choate  11-20-02 

Natalie Choate, author of Life and Death Planning for Retirement Benefits, answers your questions about estate planning and retirement benefits.

An employee who receives a distribution of employer stock from a retirement plan may qualify for a special tax deal: If the stock has appreciated since it was placed in the employee's account, the net unrealized appreciation (NUA) is not taxed until the employee sells the stock--at which time it is taxed as long-term capital gains (maximum rate 20%).

This favorable treatment is available only for stock of the employer that sponsors the plan and only if one of the following two conditions is met: either 1) the stock is distributed as part of a lump sum distribution or 2) the stock was purchased with the employee's own aftertax contributions to the plan.

Here are the questions I receive most often regarding the special NUA tax deal:

Q. Can I cause my 401(k) plan account to buy lots of employer stock just before I retire, so that I can take advantage of the NUA deal?

Natalie: The NUA deal applies only to the appreciation that occurs between the time the stock is placed in your account and the time the stock is distributed to you. If the stock is placed in your account shortly before it is distributed to you, there will presumably be little or no appreciation, so this maneuver doesn't get you anywhere.

Q. To get the favorable tax treatment, do I have to withdraw all the assets from my account in the plan? Or just the stock?

Natalie: A lump sum distribution means a distribution of 100% of your interest in the plan--not just the stock, but all assets in your account. Furthermore, the IRS may combine several plans for this purpose, so you might have to take out 100% of more than one plan to qualify. Fortunately, if you do receive other assets as part of your lump-sum distribution, you can roll the other assets over to an IRA tax-free and still get the favorable NUA treatment for the stock.

If the distribution to you does not meet the technical requirements of a lump-sum distribution, the NUA deal is available only for stock you paid for with your own (employee) contributions to the plan--if any.

Q. Can I pass this NUA advantage on to my beneficiaries?

Natalie: Yes. If the stock is still in the plan at your death, and it is distributed to your beneficiaries as part of a qualifying distribution, they will be taxed on the NUA portion (at the long-term capital-gains rate) only when they later sell the stock.

Q. Would it be better for my beneficiaries if I took the distribution during my life and then left the NUA stock to them in my will, so they get a stepped-up basis?

Natalie: The IRS' position is that your beneficiaries do not get a stepped-up basis for the NUA portion of the stock value, even if you took distribution of the stock during your lifetime. However, there can still be advantages to taking the distribution of NUA stock prior to your death, if your goal is to pass this stock on to your heirs:

1. All assets in the account must be distributed to qualify for lump-sum distribution treatment. If your account holds other assets besides the NUA stock, and the total distribution occurs while you are alive, you can roll over the other assets tax-free to an IRA. That way, you can leave your heirs the NUA stock (under your will) and also leave them the IRA (for continued tax-deferred growth). If the distribution does not occur until after your death, your non-spouse beneficiaries cannot roll over any portion of the distribution. Thus, to take advantage of the low tax rate on the NUA stock, they would have to give up further income tax deferral on all the other assets.

2. If the NUA stock continues to appreciate after it is distributed to you, and you hold it until your death, the beneficiaries will get a stepped-up basis for the appreciation that occurred after the stock was distributed to you. Only the NUA that existed at the time of the distribution does not get a stepped-up basis.

Q. What are the planning considerations if I have NUA stock?

Natalie: The "blessing" of NUA stock comes at a price of more complicated planning decisions. Lack of investment diversification is the major drawback of holding substantial amounts of employer stock in your plan account; review the risks and benefits with a qualified advisor.

Assuming you are satisfied with the amount of employer stock in your plan (or if you have no choice about the plan investment), the next decision comes when it is time to take a distribution (usually termination of employment). Should you take the distribution, sell the stock, and pay the tax, to take advantage of the low tax rate on the NUA? Or should you roll over your plan balance to an IRA and give up the NUA deal, but benefit from longer income tax deferral? The answer to this varies depending on your age and how much NUA there is relative to the total stock value. If you are younger than 59½, the 10% premature distributions penalty generally will apply to the non-NUA portion of your distribution, if you do not roll over the distribution.

Once you have decided to take a stock distribution, start the process early in the year. Ask the plan administrator to confirm that the distribution qualifies as a lump-sum distribution; the administrator should know whether the plan must be aggregated with other plans. Also ask the administrator what is the employer's cost of the stock (so you can compute the NUA). The employer is required to provide this information when it files Form 1099-R for your distribution in January of the next year; try to get them to give you the information a little earlier than that!

Citations and Resources

For more on NUA, see IRC § 402(e)(4) and Section 2.4 of Life and Death Planning for Retirement Benefits.

For more on stepped-up basis (deaths before or after 2010), see IRC § 1014 and Rev. Rul. 75-125, 1975-1 C.B. 254.

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