IRC 402 allows employees to take a lump-sum distribution of their qualified plan, pay ordinary income tax on the cost basis, and then pay long-term capital gains on the growth, even if they sell it the same day. Does this sound too good to be true? It’s actually an excellent way to take distributions on highly appreciated company stock. It may even be a more advantageous way of taking a distribution on the stock than rolling it over into another retirement plan, like an IRA – at least in certain cases.

the NUA strategy is not merely an opportunity for “free” tax savings, by turning what would be an ordinary income distribution from a retirement account into capital gains treatment on the NUA gain. Instead, it’s more of a trade-off – a decision to pay taxes sooner, at a blend of ordinary income rates on the cost basis immediately and long-term capital gains on the NUA gain when liquidated, rather than pay all ordinary income at what might have been a much later point in time.

https://www.kitces.com/blog/net-unrealized-appreciation-irs-rules-nua-from-401k-and-esop-plans/

https://www.goodfinancialcents.com/net-unrealized-appreciation/

Qualifications For NUA To Work:

In order to set up an NUA, there’s a long list of requirements that must be met:

  1. The employee must take a lump-sum distribution from the retirement plan.
  2. No partial distributions are permitted – the lump sum distribution must take place within one year of a) separation from your employer, b) reaching the minimum age for distribution, c) becoming disabled, or d) being deceased.
  3. The distribution must include all assets from all accountssponsored by and held through the same employer
  4. All stock distributions must be taken as shares – they cannot have been converted to cash prior to distribution.
  5. The entire vested interest in the retirement plan must be distributed.
  6. The employee may be subject to 10% penalty for premature distribution if he or she is under age 59 ½, unless the employee meets an exception to the premature distribution penalty under section 72(t).
  7. The cost basis is the Fair Market Value (FMV) of the stock at time of purchase, regardless of whether the employer or employee contributed the money.
  8. The NUA does not receive a step-up in basis upon death, it is instead treated as income in respect of a decedent.
  9. If there is any additional gain above the NUA, the long-term/short-term capital gains will be decided looking at the holding period after distribution.
  10. No Required Minimum Distributions (RMDs) are required.

 The lump-sum distribution must be made after a “triggering event”. In order to be eligible for NUA treatment of an in-kind distribution of employer stock, the lump-sum distribution must be made after a triggering event. The triggering events are (a) Death, (b) Disability, (c) Separation from Service, or (d) Reaching age 59 ½. Notably, this means that an in-service distribution generally does not qualify for NUA treatment, unless it is a distribution that also happens to occur after a triggering event (e.g., upon reaching age 59 ½).

How to report NUA -

Rolling over some of the shares has no effect on the basis of the shares retained. The 1099R should show the FMV of the 200 shares in the Gross distribution box (box 1). The NUA goes in box 6. The Taxable amount (box 2a) will have a figure that may or may not be the cost of the NUA shares - this box is also reduced by any after tax basis in the plan. This gets complicated because often there is usually only one 1099R that reports the entire distribution - even though there are different tax treatments for different pieces. Let's assume that the only thing on the 1099R is the FMV of the shares and the taxable amount is the basis of the NUA shares. When this is reported on the tax return, the gross amount is listed - rollover is indicated on the return and the taxable amount is the plan cost of the shares not rolled over.

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Because there’s no particular requirement that the NUA stock be sold immediately (though it often is, for diversification purposes, but could be held for months, years, or even decades thereafter), the NUA gains may be deferred for an extended period of time. Only the original cost basis of the shares (inside the plan) is taxable at the time of distribution. Although notably, the NUA gain will eventually be taxed, as it is not eligible for a step-up in basis at death (under Revenue Ruling 75-125). On the other hand, under Treasury Regulation 1.411-8(b)(4)(ii), the NUA gain is also not subject to the 3.8% Medicare surtax on net investment income (just the standard long-term capital gains tax rates of 0%, 15%, or 20%, plus state income taxes where applicable).