Net Unrealized Appreciation: Employer Stock Out of a 401(k)

How it works

Normally every dollar coming out of a 401(k) or other qualified plan is ordinary income. Section 402(e)(4) carves out employer securities. In a lump-sum distribution that includes employer stock, the net unrealized appreciation (the stock's value above the plan's cost basis) is excluded from income at distribution. You pay ordinary income tax only on the cost basis.

When you later sell the shares, the NUA is long-term capital gain regardless of how long you held the shares after the distribution. Growth after the distribution is long-term or short-term based on your holding period from the distribution date. The rest of the account (cash, mutual funds) can be rolled to an IRA in the same distribution year and stay tax-deferred.

The lump-sum distribution requirements

Under Section 402(e)(4)(D), a lump-sum distribution is the distribution within one taxable year of the entire balance to the employee's credit, after a triggering event:

• death,
• reaching age 59½,
• separation from service (employees only), or
• disability (self-employed individuals only).

All plans of the same type maintained by the employer are aggregated, so every such plan balance has to be emptied in the same tax year. An earlier partial withdrawal after a triggering event can spoil NUA treatment until the next triggering event. Plan administrators report the NUA on Form 1099-R, and IRS Publication 575 explains the reporting.

Who it fits, and who it does not

Good fit: employees and business owners whose plan holds employer stock with a low cost basis relative to its value, who have hit a triggering event, and who can pay ordinary tax on the basis now. Often relevant when a company is sold or goes public and long-time employees separate from service.

Poor fit: stock with a high basis relative to value (little NUA to convert); people who need the plan to remain fully tax-deferred for decades; anyone who already took a partial distribution after the triggering event; people under 55 at separation who would pay the 10 percent early distribution penalty under Section 72(t) on the basis portion.

Worked example

Assumptions (site tax engine, 2026 federal law, labeled): married filing jointly, no other income, age 60, employer stock in the 401(k) worth $1,000,000 with a plan cost basis of $100,000, all reported in 2026. Federal income tax only (no state).

On these assumptions, the NUA path costs $124,571 less in federal tax than withdrawing the same value from an IRA in the same year. Neither path owes the net investment income tax: plan distributions are excluded, and Treas. Reg. 1.1411-8(b)(4)(ii) treats NUA realized on a later sale as a distribution, not investment income. Growth after the distribution is investment income. A real comparison should also model the IRA path spread over many years at lower brackets, which narrows the gap.

IRS stance and audit risk

NUA is a statutory rule, not an aggressive position. Errors come from mechanics:

• Missing the one-tax-year requirement or forgetting another plan of the same type.
• Rolling the stock to an IRA first. Once in an IRA, NUA treatment is gone.
• Misreporting basis on the later sale. Your basis in the shares is the amount taxed at distribution, and the NUA portion is long-term gain.
• Death. NUA is income in respect of a decedent. Under Section 1014(c) and Rev. Rul. 75-125, the NUA in unsold shares does not get a step-up at death; heirs pay long-term capital gain on it when they sell. Appreciation after the distribution can be stepped up.

Costs and fees

No product cost. The cost is the ordinary income tax on the plan's basis in the distribution year (plus a possible 10 percent penalty under age 55 at separation or 59½), giving up tax deferral on the stock, and concentration risk if you keep a large single-stock position. Brokerage transfer fees are minor.

How it compares with a Section 453 installment sale

NUA and a Section 453 installment sale are not substitutes; NUA applies only to employer stock in a qualified plan, while installment reporting applies to sales of property. They interact through timing. A seller who closes a business sale and separates from service in the same year may stack ordinary income on the stock's basis on top of the sale gain. Spreading the sale gain on a note, or timing the plan distribution into a lower-income year, can keep more of each in lower brackets. Shares received by NUA can also be sold over several years to manage brackets, the same idea behind 0 percent capital gains harvesting. See also year-end timing.

Frequently asked questions