The Tax Break Hiding in Your Old 401(k)

Spoiler alert: if you've got company stock sitting in an old employer's 401(k), the IRS built a loophole with your name on it. Most people never hear about it because it only shows up in the fine print, and nobody reads the fine print. That's what we're here for.

It's called net unrealized appreciation, or NUA for short, and it is not, despite how it sounds, a symptom you should call your doctor about.

So what actually is NUA?

Let's say you worked somewhere for years and the company kept handing you stock inside your 401(k). Over time you put in $20,000 worth, and it's now sitting at $120,000. That $100,000 of growth is the "net unrealized appreciation."

Normally, every dollar that comes out of a 401(k), growth included, gets taxed as ordinary income. It doesn't matter if the money came from cash contributions or stock that tripled. Ordinary income is ordinary income, and depending on your bracket, that can sting.

Employer stock gets a rare exception. Instead of that $100,000 of growth getting taxed at your ordinary rate, it can be taxed at long-term capital gains rates, which top out well below the top ordinary bracket. You still owe ordinary income tax on the original $20,000 basis right away. But the growth doesn't get taxed until you actually sell the shares, and when it does, it's taxed as a long-term gain no matter how long you personally held it.¹

Roll that same stock into an IRA instead, which is the default move most people make without thinking twice, and you torch this entire benefit. Every dollar that eventually comes out of an IRA is ordinary income. The stock market doesn't care how it got there. The IRS does.

The rules aren't optional

This only works if a few boxes get checked, in order:

• The stock has to leave the plan as actual shares into a regular taxable brokerage account. Not cash. Not a rollover. Shares.
• It has to be part of a full distribution of the entire plan balance in one calendar year. The stock portion goes to a brokerage account, but everything else in the plan can still roll into an IRA.
• It can only happen after what the IRS calls a "triggering event": you leave the company, you turn 59 1/2, you become disabled, or you pass away.²

Miss any one of those and you don't get a second try until another triggering event comes along. This is a one-shot decision, made once, usually right around retirement, which is exactly the wrong time to be guessing.

When it's worth it, and when it's really not

NUA shines when your cost basis is small compared to what the stock is worth today, meaning most of the position is pure growth. Someone who's held company stock for decades at a low basis is sitting on a great candidate. Someone whose basis is closer to half the stock's current value is paying a big ordinary income tax bill upfront for a benefit that might take a decade or more to actually beat just rolling everything into an IRA and letting it compound.³

There's also a wrinkle that catches people off guard: NUA shares don't get a step-up in basis when they pass to your heirs, unlike most everything else in your estate.⁴ That's one more variable in a decision that shouldn't be made from a newsletter, charming as we like to think this one is.

The bottom line

NUA is one of the more valuable, least-talked-about moves available to someone leaving a company with a pile of employer stock in their retirement plan. It's also completely wrong for plenty of people, and there's no undo button once you've made the election. If you've got employer stock in an old 401(k) and you're anywhere near a job change or retirement, let's run the numbers together before anything rolls anywhere.

This is general education, not personalized tax or investment advice. Your plan's rules and your own numbers matter here.

Sources

1. IRS, "Topic no. 412, Lump-sum distributions," confirms net unrealized appreciation in employer securities is "generally not subject to tax until you sell the securities," with an election available to include it in income sooner. irs.gov/taxtopics/tc412
2. IRS Notice 98-24 lays out the original guidance on how NUA is calculated and taxed under IRC Section 402(e)(4), including the distribution and triggering-event requirements. irs.gov/pub/irs-drop/not98-24.pdf
3. Michael Kitces, "401(k) Net Unrealized Appreciation (NUA) Rules and Caveats," Kitces.com, walks through break-even modeling on when NUA outperforms an IRA rollover based on cost-basis percentage. kitces.com
4. Per IRS Revenue Ruling 75-125, NUA does not receive a step-up in basis at death, unlike most inherited assets.