Net Unrealized Appreciation (NUA)

How it works

A qualified retirement plan, a 401(k), an ESOP, a profit-sharing plan, or a pension plan, can hold stock of the company that sponsors it. When that plan distributes the stock to the employee, section 402(e)(4)(B) allows an election most people have never heard of: only the plan's cost basis in the stock is taxed as ordinary income at distribution. The net unrealized appreciation, the built-in gain above that basis, is excluded from income at distribution and taxed only when the shares are later sold, as long-term capital gain. The regulation defines the number precisely: the excess of the stock's market value at distribution over the plan's cost or other basis (Treas. Reg. 1.402(a)-1(b)(1)); the plan reports the two pieces separately on Form 1099-R, with the untaxed NUA amount in Box 6.

What makes this worth planning around, rather than a quirk of the distribution rules, is a second feature layered on top of the exclusion. Under IRS Notice 98-24, the NUA amount is treated as gain on a capital asset held long-term, automatically, whenever it is realized on a later sale, regardless of how long the employee held the shares inside the plan or how quickly they sell after distribution; Publication 575 confirms the same treatment for a current lump-sum distribution of employer securities. Anything the stock does after distribution is a separate question with its own clock: further appreciation follows the distributee's actual holding period from that point forward, long-term only if held more than a year after distribution. The NUA layer's clock never starts; the post-distribution layer's clock starts fresh the day the shares leave the plan.

NUA treatment is the default on a qualifying distribution, not something affirmatively claimed. Section 402(e)(4)(B) also lets the taxpayer elect out of it and take the full value as ordinary income instead, an election rarely worth making but easy to trigger by accident on a return prepared without knowing the stock was distributed in kind.

What this is worth in Florida

Less than the mechanism suggests, and worth saying plainly. Florida has no individual income tax (Fla. Const. art. VII), so neither the ordinary income on the plan's cost basis nor the eventual capital gain on the NUA ever had a state layer to plan around; both are federal-only. There is no Florida-specific reason to prefer this over a rollover.

Who this applies to

This question only comes up at a specific moment: someone is separating from a job, turning 59½ while still employed, becoming disabled, or a beneficiary is receiving a deceased participant's account, and the account holds stock of the corporation that sponsored the plan. "Securities of the employer corporation" reaches shares of stock, and bonds or debentures with interest coupons or in registered form, of the employer and of its parent or subsidiary corporations (section 402(e)(4)(E)). A C corporation qualifies, and so does an S corporation; it is still a corporation for this purpose even though its income passes through to the owner's own return, and an owner drawing salary as its employee is a common-law employee for the triggering-event gate covered below.

What does not qualify, structurally, is anything that is not a corporation at all. An LLC, a partnership, or a sole proprietorship issues no "securities" under this definition and can never generate its own NUA, no matter how it is taxed. This does not come up because of a client's own business structure; it comes up because a client, or a client's spouse, has employer stock sitting inside a 401(k), ESOP, profit-sharing plan, or pension plan at a day job, current or past, where the employer happens to be a corporation that funded the plan with its own shares. A solo 401(k) or a SEP-IRA a business owner sets up for their own self-employment income, the kind of choice I compare in my solo 401(k) vs. SEP-IRA guide, is a different question: NUA is never about the plan an owner builds for their own business, only about one someone else's corporation built for its employees.

What it requires

Four conditions have to be true at once. There is no partial version of this: miss any one of the four and NUA treatment is unavailable.

• The stock is distributed in kind. The exclusion runs on "that part of the distribution which consists of securities of the employer corporation" (section 402(e)(4)(B)). If the plan sells the stock first and pays cash instead, there is no security in the distribution for the exclusion to attach to.
• The distribution is a true lump sum. Section 402(e)(4)(D)(i) requires the entire balance to the employee's credit, and the aggregation rule in (D)(ii) treats every pension plan the employer maintains as one plan, every profit-sharing plan as one plan, and every stock-bonus plan as one plan, each tested separately, so the whole balance across every plan of that kind must reach zero within a single taxable year, not just the account holding the stock. That reaches only pension, profit-sharing, and stock-bonus plans under section 401(a), not a separate 403(b) or governmental 457(b) balance with the same employer.
• A qualifying event triggers the distribution, and which events qualify depends on who the recipient is. Section 402(e)(4)(D)(i) lists death, age 59½, separation from service, or disability, then splits the last two by employment category: separation from service reaches only an employee without regard to section 401(c)(1), and disability only a self-employed individual within that same section. The two triggers do not swap; death and 59½ are open to both. An S corporation owner-employee gets the separation-from-service trigger; a sole proprietor or partner does not, and is limited to death, 59½, or disability.
• Every plan of that kind is actually zeroed out, confirmed before anything moves rather than assumed. A balance left in a companion plan, even a small one, breaks the lump-sum test for the whole distribution under the aggregation rule above, not just for the leftover piece.

Worth knowing rather than assuming: if the recipient is under 59½, section 72(t)(1) imposes its ten percent additional tax only on the cost-basis piece, since excluded NUA is never part of that penalty base. Section 72(t)(2)(A)(v) exempts amounts paid after separation from service after age 55, available only to a common-law employee, since that exception runs through the separation-from-service trigger.

What you need to document

Almost everything that can go wrong here is a documentation failure discovered after the distribution has already happened, when it is too late to fix. The file has to exist before the rollover paperwork is signed, not after.

The plan's cost basis in the stock, by lot, in writing

From the plan administrator, before any election is made. This number drives the entire ordinary-income figure for the year and cannot be reconstructed once the shares leave the plan. Confirm the fair market value as of the intended distribution date at the same time.

Written confirmation of which triggering event applies

Death, age 59½, separation from service, or disability, matched against whether the recipient is a common-law employee or a self-employed individual under section 401(c)(1). Getting this backward is invisible until the distribution has already happened.

Zero-balance confirmation across every plan of that kind

A statement that every pension, profit-sharing, and stock-bonus plan the employer maintains will carry a zero balance for this employee within the same taxable year, and whether a late contribution, a profit-sharing true-up being the common example, is expected to post to a companion plan afterward. An allocation landing after the fact can undo the test retroactively.

Confirmation the shares move as shares

In writing, from the plan, that the employer stock will be distributed in kind rather than liquidated first. Other assets in the account, mutual funds or cash, can still move to an IRA in the same transaction without disturbing NUA on the stock.

Whether the plan tracks specific lots to this employee's account

Treas. Reg. 1.402(a)-1(b)(2)(ii)(A) lets a security's own earmarked cost basis control when the recordkeeping ties that lot to the employee rather than pooling it. Whether that tracking exists is a factual question for the administrator, not an assumption, and it changes what basis figure is even available.

Where it goes wrong

This is not an audit-risk position. NUA is not a listed or reportable transaction, and there is no aggressive interpretation for an examiner to challenge. The risk here is different in kind: an irreversible-error risk, where a mistake made once cannot be corrected afterward at any cost.

The two mistakes with no fix

Rolling any portion of the employer stock itself into an IRA forfeits NUA on those shares permanently: every dollar that later comes out of the IRA is ordinary income, for the rest of that account's life. The same is true if the plan sells the stock before distribution rather than distributing it in kind: once the distribution is cash, section 402(e)(4)(B) has nothing to attach to.

Once the stock is inside an IRA, or once the plan has liquidated it before distribution, no election, no amended return, and no private letter ruling brings NUA treatment back.

The other ways this goes sideways

• A companion plan carries a balance nobody accounted for. Because the aggregation rule tests the entire balance across every plan of that kind, a leftover amount anywhere breaks lump-sum status for the whole distribution, not proportionally, including a late contribution allocated to a companion plan after the distribution already happened.
• Modeling one blended tax rate on the whole eventual sale. Treas. Reg. 1.1411-8(b)(4)(ii) excludes the NUA layer from net investment income entirely, but treats further appreciation after distribution as fully exposed to the 3.8 percent surtax once modified adjusted gross income clears the section 1411(b) threshold, $250,000 on a joint return. A projection that ignores the split misstates the total.
• Assuming death rescues an unrealized position the way it usually does. Appreciated property ordinarily gets a basis step-up at death that erases the built-in gain; unrealized NUA does not, because it is income in respect of a decedent under section 691(a) (the holding of Rev. Rul. 75-125), which section 1014(c) carves out of the step-up rules, even though post-distribution appreciation on the identical shares does step up. Section 691(c) offers a partially offsetting income-tax deduction for the estate tax attributable to that income, but it does not erase the layer. More on how the step-up ordinarily works is in Step-Up in Basis Planning.
• Not accounting for a Roth conversion planned for the same year. The cost basis recognized on an NUA distribution is ordinary income, and it competes for the same limited bracket space as a Roth conversion sized without the distribution in mind. Running both in the same year is not prohibited; running both without modeling them together usually pushes one, or both, into a higher bracket than either alone would have reached.

A situation where this comes up

The clean version is someone separating from a corporate employer in their late fifties or early sixties, with employer stock that has sat inside the company's 401(k) or ESOP for years, appreciating well beyond what was ever contributed. A low basis relative to the stock's current value, plus a reasonable prospect of diversifying out of a concentrated position within a few years, is the fact pattern where taking the shares in kind, and paying ordinary tax on a small basis figure now in exchange for long-term treatment on the rest, tends to compare well against a full IRA rollover.

The harder version runs the other way: the plan's cost basis makes up most of the current value, so there is much less excluded income relative to the ordinary income it triggers immediately. If that same person also has a genuine ability to draw a traditional IRA down gradually across many future years, in brackets meaningfully lower than the one this distribution would land in today, a full rollover keeps more options open than locking in today's rate up front. Which side a given case falls on is a modeling question, not a rule of thumb.

The version that concerns me is the one where nobody ever asked the question. A rollover election gets signed, employer stock included, without anyone first pulling the lot-level cost basis or checking whether an in-kind distribution was even considered. By the time anyone notices what was actually sitting in that account, the stock is already inside the IRA, and whatever NUA existed on it is gone permanently. That window closes the moment the paperwork is signed.