Your Guide to the NUA Rule (Net Unrealized Appreciation)

With so many publicly traded companies located here in Minnesota (United Health, Target, Best Buy, Medtronic, US Bank, General Mills) it’s not surprising that we often have questions about the NUA rule. Anyone who has worked with one of these companies over a significant period of time may be looking at a large concentrated stock positions with a potentially huge tax burden in the near future. The NUA rule may help alleviate some of that burden but you have to do it the right way.

What is the NUA Rule

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NUA stands for Net Unrealized Appreciation. This is just the gain that you have built up over the years by holding your stock. The NUA Rule is a part of the Federal tax law that applies to distributions of company stock from a qualified plan such as a 401(k). According to this rule, you will only be taxed on the cost basis of the stock at the time of distribution. Keep in mind there is still the potential for an early withdrawal penalty depending on when you distribute the shares. The cost basis is what you paid for the stock and is likely made up of multiple purchases over the years. Your custodian (where the shares are held) should have your cost basis or at least help you find the information to calculate it yourself. The difference, then, between your cost basis and the current value of the stock is your Net Unrealized Appreciation or NUA. This NUA is not taxed when the company stock is distributed, but when the stock is sold (and never subject to the early withdrawal penalty). As well, the NUA is taxed at favorable long-term capital gains rates rather than ordinary income rates. Additionally, the NUA is not subject to the 3.8% Medicare Surtax on Net Investment Income (NIIT). The big picture is that by utilizing the NUA rule you will likely be paying much less tax.

An Example of the NUA Rule in Action

Let’s say you work at United Health Group and you’ve purchased $100,000 in UNH stock in your 401(k) plan over many years and it now has a market value of $500,000.

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Following the Rules

In order for the $400,000 NUA to qualify for special tax treatment you need to follow the rules. You can read more from the IRS here, however there are two main rules that I want to outline here:

  1. Lump Sum Distribution – The distribution must be done in one lump sum, meaning you must distribute the entire balance when you separate from service, die, are disabled, or have turned 591/2. This distribution needs to be completed in the same as one of these criteria.

  2. In-Kind Distribution – You need to keep your company stock as company stock. You cannot sell and go to cash prior to the distribution. If you hold UNH stock it needs to stay UNH stock during the distribution. You also cannot roll your stock into an IRA. In doing so you would lose your ability to utilize the NUA rule. The distribution must come from your 401(k). However, this does not mean that you cannot roll over the other assets in your 401(k) into an IRA to continue to keep the tax deferred growth. Indeed, for most people this is gong to be the suggested strategy. In our example, if in addition to your $500,000 of UNH stock you also have $500,000 of other investments, half would go to an IRA the other half (UNH stock) would go to your taxable brokerage account.

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Who Should Use the NUA Rule

Obviously, this rule makes sense for people with large concentrated stock positions in a qualified plan, like in our example. However, you also need to have the cash or income to pay the tax on the stock distribution at the time of the distribution, which can be significant. However, as you will see, paying some tax now is more beneficial than paying a lot of tax later. To see this, we’ll continue with our example, however, I’ll provide a little more information. The person, let’s call him Stephen H., is retiring at age 65 after working with United Health Group for quite some time. Stephen has two options:

  1. Rollover the Entire 401(k) into an IRA (not utilizing the NUA Rule) – After separating from service, Stephen can roll his entire $1mm 401(k) balance into his IRA. This is not a bad idea, as he is able to continue to defer the growth of his portfolio until he needs the money for retirement expenses. However, when the money is finally withdrawn, he is paying taxes at his ordinary income tax rate, which we’ll say is 37%. So, the tax related to the UNH stock is $185,000.

  2. Utilize NUA Rule – Instead of rolling everything into his IRA he puts the $500,000 of UNH stock into his brokerage account and rolls the remaining investments into his IRA. This allows him to pay capital gains rates of 20% on the NUA when the stock is eventually sold. The total tax bill would be $117,000, which is made up of $37,000 ordinary income tax on the $100,000 of cost basis, and $80,0000 of the long-term capital gains (20% of $400,000 NUA).

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In this case, Stephen is saving $68,000 by utilizing the NUA rule. Not bad. But also keep in mind he had to pay the $37,000 right away due to the distribution. Then if he sold the stock to diversify his portfolio, he would have to pay the remaining $80,000 when he sold. Depending on his cash situation, this could outweigh the tax savings. Keep in mind, he does not have sell the stock right away but may want to in order to remove the risk of holding a single stock position. Alternatively, if he performed the rollover, he could sell the stock to diversify but only pays the tax when the money is distributed. He also has more control over when he takes distributions form his IRA and might be able to get the money out at less than 37% by utilizing a Retirement Withdrawal Strategy and managing his tax brackets.  As you can tell there are a lot of nuances to this type of strategy so talk with your fee-only fiduciary financial advisor to see if this strategy makes sense for you. 

Down Markets Are Better for NUA Strategy

Big drops in the market, and therefore, your company stock, are one of the best times plan for this type of strategy. When the markets are down, you can sell your company stock in your 401(k) and repurchase soon after to “reset the basis.” The wash sale rule does not apply in a 401(k) so if you can reduce your cost basis, using the NUA rule will be even better since you will be paying less ordinary income tax on the lowered basis.

Decision Time

As I mentioned earlier you definitely want to consult your financial advisor or tax preparer (bonus points if your financial advisor is your tax preparer) before executing this type of strategy. However, below is a quick summary to see if you should be considering this for yourself:

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If you have questions about your concentrated stock position, utilizing the NUA rule, or how this all relates to your retirement plan, schedule a phone call to discuss with a Phillip James advisor.

All the information contained herein is for illustrative purposes and should not be relied upon for tax, investment, or legal advice. You should consult with your retirement advisors to decide what is best for you based on your specific situation. It also helps if your advisor is also a tax preparer.

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