Understanding Net Unrealized Appreciation

Many 401(k) participants decide to roll their company retirement accounts into IRAs, with or without annuities, for greater investment flexibility.

For some retirees, however, rolling over the entire 401(k) may be overlooking a key opportunity.

Employees that have significant gains in company stock have another option: a net unrealized appreciation, or NUA, election. As markets trade at all-time highs, this is an election that should not be overlooked.

Of course, given that this article addresses complicated tax matter, and tax rules may have complicated nuances and evolve rapidly, keep the following warnings in mind before reading further about the topic.

• This material is for informational purposes only, and is not a recommendation to buy, sell, hold or roll over any asset.
• The material does not take into account the specific financial circumstances, investment objectives, risk tolerance or need of any specific person.
• Eagle Life Insurance Company does not offer legal, investment or tax advice or make recommendations regarding insurance or investment products. Please consult a qualified professional before discussing this with clients, and please ask clients to talk to a qualified professional before making any decisions about retirement plan withdrawals.
• This article was published in May 2024 and may be impacted by future developments.

Introduction to NUA Elections

An NUA election allows retirement plan holders to withdraw company stock and send it to a non-qualified investment account.

The basics of a NUA transaction are relatively straightforward. The participant can withdraw the stock from the plan and pay ordinary income tax on the basis only. (See Internal Revenue Code section 402(e)(4).) The difference between the basis and the market value at the time of the withdrawal is known as the net unrealized appreciation or NUA.

When the stock is sold, the NUA is realized, and only then are gains taxed at the client’s capital gain rate. (See Internal Revenue Service Notice 98-24.)

The difference between the individual’s ordinary income rate and capital gains tax rate will determine their tax savings. Additionally, NUA stock will not be subject to RMDs, which provides for more flexibility in a retirement plan.

NUA in Action

You have $500,000 of company stock with a basis of $100,000 in your 401(k). Your ordinary income tax rate is 25%, and your capital gains tax rate is 15%.

Without NUA: You sell the stock and roll over the proceeds to an IRA and begin taking distributions at your ordinary income tax rate, resulting in $125,000 in taxes.

With NUA: You pay ordinary income taxes on the basis equaling $25,000. When you eventually sell the NUA stock outside your retirement account, you’ll pay capital gains of $60,000. Total taxes utilizing NUA are $85,000, resulting in a $40,000 tax savings.

NUA Eligibility: Avoiding Pitfalls

While NUA offers a powerful tax-saving opportunity, there are two strict eligibility rules to follow:

Lump sum distribution: You must distribute all assets from your plan, including both company stock and other investments, typically rolling the latter into an IRA. This distribution needs to happen within a single tax year.

Triggering event: NUA requires a triggering event such as reaching age 59 ½, separation from service, death, or disability.

Unwittingly Disqualifying Yourself From NUA

The problem many investors face is they may unknowingly engage in a transaction that disqualifies them from electing NUA in the future. Any partial distribution taken after a qualifying event will nullify the lump-sum distribution requirement in future years. These would include:

• Partial rollovers.
• In-service distributions.
• Ordinary distributions.
• RMDs.
• In-plan Roth conversions.

When these transactions take place, the ability to elect NUA is lost until the next qualifying event, which, in some circumstances, means it will be lost for the life of the client. Consequently, undertaking NUA elections should be done with extreme care.