Net Unrealized Appreciation (NUA): Pros, Cons, and When It Actually Saves Taxes
If you have employer stock inside a qualified retirement plan (most commonly a 401(k), profit-sharing plan, or ESOP), the Net Unrealized Appreciation (“NUA”) rules can let you shift part of what would otherwise be ordinary income into long-term capital gains. This sometimes producing meaningful lifetime tax savings. With that said, NUA is not always good. It’s a tax election with strict rules, cash-flow implications, and real portfolio risk. Below is a practical, decision-oriented overview, with specific IRS authority and two numeric examples.
What NUA Is (in IRS Terms)
NUA is generally the increase in value of employer stock while it was held inside the plan—i.e., fair market value at distribution minus the plan’s cost basis in those shares. The favorable treatment comes from IRC §402(e)(4) and related regulations.
The tax “split” under the NUA rules
When you take a qualifying distribution of employer stock in-kind (shares, not cash):
Ordinary income (now): You pay ordinary income tax on the stock’s cost basis in the plan (not its current market value). This is the amount typically shown as “cost” and the “NUA” amount is often shown separately. The NUA is essentially the unrealized gain on the stock. You will see the NUA number on your retirement plan website or statements sometimes listed as gain/loss. Once you comit to the NUA strategy you may receive a 1099-R that outlines the NUA specifically separate from the cost basis.
NUA (later): The NUA portion is not taxed at distribution. It is taxed when you later sell the shares, generally at long-term capital gains rates—regardless of how long you hold the stock after distribution.
Post-distribution change (later): Any additional gain (or loss) after distribution is taxed under normal capital gains rules based on your holding period in the taxable account.
The Trigger: You Don’t “Just Do NUA” Anytime
The favorable NUA treatment generally requires a lump-sum distribution after a qualifying “triggering event” (commonly separation from service; also potentially after age 59½, disability, or death). The IRS definition of a lump-sum distribution focuses on distributing the participant’s entire balance from all of the employer’s qualified plans of one kind within a single tax year.
A common planning structure is:
Distribute employer stock in-kind to a taxable brokerage account (to preserve NUA),
Roll the rest of the plan assets to an IRA (to keep them tax-deferred),
Ensure the overall “lump-sum” rules are satisfied for the employer/plan type.
You may have multiple retirement plans at work. Its important to make sure you are doing the whole lump-sum for the plan that includes the NUA. That doesn’t necessarily mean you have to do distributions from all of your retirement plans.
If you roll the employer stock into an IRA first, you generally lose the ability to use NUA on those shares.
Pros of NUA: Why People Use It
1) Potentially large rate arbitrage (ordinary income vs. long term capital gain)
The core benefit is that appreciation inside the plan can be taxed at long-term capital gains rates instead of ordinary income rates.
2) You can control the timing of the capital gains tax
You pay ordinary income tax on basis in the year of distribution, but you control when to sell the shares and recognize the capital gain (NUA + post-distribution gain). This can help manage multi-year tax brackets and timing around retirement, relocation, or income changes.
3) No required holding period for the NUA portion to be LTCG
NUA is generally treated as long-term capital gain when sold even if you sell soon after distribution (the “long-term” characterization applies to the NUA element itself).
4) Strategic use in “income gap” years (planning flexibility)
Many retirees have a lower-income window between retirement and Social Security/RMDs. NUA can be timed to fit those years.
Cons of NUA (Where It Bites People)
1) Cash-flow pain: you owe ordinary income tax on basis immediately
At distribution, you’re taxed on the plan’s cost basis, which can still be a big number. If you don’t have cash, you may be forced to sell shares quickly (which might be fine, but it should be planned).
2) Concentration risk becomes real the moment shares hit taxable
Inside the plan, people often ignore concentration. After distribution, if you hold, you’ve now got career risk, equity risk, and potentially a large portfolio position in one security.
3) NIIT and state taxes can reduce the benefit
High-income households often owe the 3.8% Net Investment Income Tax on capital gains, and state taxes may apply. That narrows the spread between ordinary and capital gain rates.
4) Strict eligibility rules and execution risk
If you miss the lump-sum distribution requirements, distribute incorrectly, or roll employer stock into an IRA, you can accidentally forfeit NUA treatment. IRS guidance describing the special rule and what happens with rollovers appears in IRS notices and Publication 575.
5) Early distribution penalty considerations (age-related)
If you are under 59½, the 10% additional tax under IRC §72(t) can apply to the taxable portion of certain plan distributions. NUA itself is generally not included in income at distribution, but the ordinary-income piece (basis) may still be penalty-exposed unless an exception applies.
6) You move assets from tax-deferred to taxable
Once shares are in taxable:
Dividends are taxable annually
Future gains are taxable when sold
This can be fine—especially if you sell quickly and diversify—but it’s a real tradeoff.
Two Examples (high bracket vs. lower bracket)
Assumptions in both examples:
Employer stock inside 401(k)
Cost basis in the plan: $200,000
Fair market value at distribution: $1,000,000
NUA: $800,000
You distribute the shares in-kind to taxable and immediately sell (to simplify timing)
Ignore state taxes; include NIIT where relevant
Example A: High tax bracket household (top bracket; LTCG + NIIT)
Ordinary income tax rate: 37%
Long-term capital gains rate: 20%
NIIT: 3.8%
With NUA:
Ordinary income on basis: $200,000 × 37% = $74,000
Capital gain on NUA: $800,000 × 23.8% = $190,400
Total federal tax (approx.): $264,400
Without NUA (roll to IRA, later distribute all as ordinary income):
Ordinary income on full $1,000,000: $1,000,000 × 37% = $370,000
Approximate tax difference: $105,600 tax savings
Why it works here: you’re converting a large portion of what would be 37% ordinary income into ~23.8% capital gains.
Example B: Lower bracket household (moderate bracket; standard LTCG)
Ordinary income tax rate: 22%
Long-term capital gains rate: 15%
Assume NIIT does not apply
With NUA:
Ordinary income on basis: $200,000 × 22% = $44,000
Capital gain on NUA: $800,000 × 15% = $120,000
Total federal tax (approx.): $164,000
Without NUA:
Ordinary income on full $1,000,000: $1,000,000 × 22% = $220,000
Approximate tax difference: $56,000 tax savings
Key nuance: the benefit can still be meaningful in lower brackets, but it depends heavily on your ordinary bracket, whether you can keep LTCG low (possibly 0% in some years), and the size of NUA relative to basis.
Practical “When NUA Is More Likely to Be Worth It”
NUA tends to be attractive when:
The stock has very low basis and very high appreciation
You’re in a high ordinary bracket now or in retirement
You can manage concentration risk by selling quickly and diversifying
You can meet the lump-sum distribution requirements and execute cleanly
NUA is less attractive when:
Basis is high (little NUA)
You expect future ordinary income rates to be much lower than today
You want to keep assets tax-deferred and avoid taxable dividends/gains
You’re forced to hold a concentrated position due to lockups or behavioral reasons
IRS Authority (Quick Reference)
IRC §402(e)(4) — Statutory framework for NUA in employer securities and lump-sum distribution treatment
Treas. Reg. §1.402(a)-1(b)(1)(i) — Determination of NUA and basis mechanics
IRS Publication 575 — IRS explanation of NUA in employer securities received as part of a lump-sum distribution
IRS Notice 2009-68 — IRS rollover notice guidance explaining NUA and how rolling employer stock affects availability of the special NUA rule
IRS Topic No. 412 — IRS explanation of lump-sum distribution concept and conditions
Bottom Line
NUA is one of the few places where the tax code still offers a meaningful rate-conversion opportunity: ordinary income into long-term capital gains on qualifying employer stock. It’s not a free lunch. It requires careful execution, thoughtful cash-flow planning, and an explicit plan for concentration risk. As always, talk to your tax professionals and wealth advisors for details about your particular situation.