Company stock held inside a 401(k), profit-sharing plan, or ESOP gets a tax break no other plan asset receives. Under the net unrealized appreciation tax rules in IRC §402(e)(4), if you take a qualifying lump-sum distribution of employer securities, you pay ordinary income tax only on what the plan originally paid for the shares. The appreciation, called net unrealized appreciation or NUA, is excluded from income at distribution and taxed at long-term capital gains rates whenever you eventually sell.1Office of the Law Revision Counsel. 26 U.S. Code 402 – Taxability of Beneficiary of Employees Trust For long-tenured employees whose stock ran up over their careers, the difference between ordinary rates and 15% or 20% capital gains can be tens of thousands of dollars. The catch is execution: the election works only if the distribution is structured precisely, and one misstep collapses the whole thing.
The Three Layers of Tax on an NUA Distribution
An NUA distribution splits into three pieces, each taxed differently.
The cost basis, meaning what the plan originally paid for the shares, is taxed as ordinary income in the year of distribution. This is the piece you cannot defer if you use the NUA election.
The NUA itself, meaning the appreciation from the plan’s purchase price up to the fair market value on the distribution date, is excluded from income at distribution. It gets taxed at long-term capital gains rates whenever you sell the shares, no matter how briefly you have owned them after distribution. Long-term treatment is baked into the rule.
Any additional appreciation after the distribution date is a normal capital gain in your brokerage account, short-term or long-term depending on how long you hold the shares after receiving them.
You can also elect out of NUA treatment on your tax return for the year of distribution, in which case the full value of the stock becomes ordinary income. That election is irrevocable, so model it before filing.1Office of the Law Revision Counsel. 26 U.S. Code 402 – Taxability of Beneficiary of Employees Trust
What Counts as a Qualifying Lump-Sum Distribution
NUA is only available on a lump-sum distribution as the IRS defines the term. That means the participant’s entire balance from all of the employer’s qualified plans of the same type is distributed within a single tax year.2Internal Revenue Service. Topic No. 412 – Lump-Sum Distributions Pension plans are grouped together, profit-sharing plans are grouped together, and stock bonus plans are grouped together. Two profit-sharing plans from the same employer must both be emptied in the same calendar year for either to qualify. A forgotten small balance in an old plan invalidates the whole thing.
The distribution also has to be triggered by one of four events:2Internal Revenue Service. Topic No. 412 – Lump-Sum Distributions
- Separation from service (common-law employees only, not the self-employed)
- Reaching age 59½
- Death (a beneficiary may elect NUA on the inherited shares)
- Disability (self-employed individuals only)
Miss any element, and NUA is off the table. The most frequent error is scattered plan balances that were never consolidated before the distribution year.
A Worked Example
Say your plan bought 1,000 shares of company stock over the years at an average of $10, so the cost basis is $10,000. On the day of your lump-sum distribution the shares trade at $110, making the fair market value $110,000.
- The $10,000 basis is ordinary income this year.
- The $100,000 of NUA is not taxed now. When you sell the shares, that $100,000 is a long-term capital gain no matter when you sell.
- Any gain above $110 per share after the distribution date is a separate capital gain, short-term if you sell within a year of distribution, long-term after that.
Sell four months later at $120, and the extra $10,000 is a short-term gain taxed at ordinary rates, while the $100,000 NUA layer still gets long-term treatment.
Compare that outcome to rolling the full $110,000 into a traditional IRA. Every dollar you eventually withdraw is ordinary income. For a filer in the 32% bracket, running the appreciation through capital gains at 15% instead of ordinary rates saves roughly $17,000 on that $100,000 alone. The lower the basis relative to the appreciation, the larger the swing.
NUA Before Age 59½
If you take the distribution before 59½, the 10% early withdrawal penalty applies, but only to the cost basis portion of the stock distributed in kind. On a $10,000 basis, that is a $1,000 penalty on top of the ordinary income tax. The penalty does not touch the NUA itself or any post-distribution appreciation.
That narrow application changes the math. A 52-year-old separating from service with a $5,000 basis and $200,000 of NUA pays a $500 penalty but preserves capital gains treatment on $200,000 of appreciation. Do not rule out NUA just because you are under 59½; the ratio of basis to appreciation is what decides.
You Can Cherry-Pick Shares
Nothing requires you to run every share through the NUA election. Treasury Regulation §1.402(a)–1(b) lets you distribute specific share lots to a taxable brokerage account for NUA treatment while rolling the rest of the shares, plus any non-stock plan assets, into an IRA.3GovInfo. 26 CFR 1.402(a)-1 – Taxability of Beneficiary Under a Trust Which Meets the Requirements of Section 401(a) The technique works only if individual lots were tracked in your account. Used well, it limits the immediate ordinary-income hit to the lots with the most favorable NUA-to-basis ratio and defers the rest inside an IRA.
What Happens to NUA Stock at Death
NUA shares do not get the full step-up in basis that most appreciated assets receive at death. The NUA portion is income in respect of a decedent, so heirs owe long-term capital gains tax on that layer when they sell. Any appreciation that occurred after the distribution, while you held the shares, does step up and disappears from the tax base. The original NUA follows the shares to the beneficiary.
Death itself is one of the four triggering events, so a beneficiary who inherits an account still holding employer securities can take a lump-sum distribution and claim NUA on their own return, as long as the full-balance-in-one-year rule is satisfied.1Office of the Law Revision Counsel. 26 U.S. Code 402 – Taxability of Beneficiary of Employees Trust
How the Distribution Shows Up on Form 1099-R
The plan administrator reports the distribution on Form 1099-R. Two boxes matter most. Box 2a, “Taxable amount,” should show the plan’s cost basis, which is what you pay ordinary income tax on this year. Box 6, “Net unrealized appreciation in employer’s securities,” should show the NUA that is excluded from current income.4Internal Revenue Service. Instructions for Forms 1099-R and 5498
The IRS instructions require the NUA to also appear in Box 1 (gross distribution) but not in Box 2a, except in certain Roth situations.4Internal Revenue Service. Instructions for Forms 1099-R and 5498 Box 7 carries the standard distribution codes: Code 1 for an early distribution, Code 7 for a normal one. There is no dedicated NUA code; the election is identified by the combination of the distribution code and the amount in Box 6.
If Box 6 is blank or the basis in Box 2a looks wrong, call the plan administrator for a corrected 1099-R before you file. Fixing it after filing is possible but much harder, and a botched form can prompt the IRS to treat the entire distribution as ordinary income.
When NUA Beats a Rollover, and When It Does Not
NUA works hardest when the cost basis is small compared to the current share price. Converting a large block of appreciation from ordinary income rates to capital gains rates is where the savings live. The 2026 long-term capital gains rate stays at 0% for lower incomes, 15% for most filers, and 20% for taxable income above $545,500 (single) or $613,700 (married filing jointly). Against a 32% or higher ordinary bracket, that spread is the whole point.
When the basis is high relative to current value, the tax savings shrink and holding a concentrated single stock outside the plan can matter more than the rate differential. Rolling the shares into an IRA keeps growth tax-deferred, lets you diversify immediately with no current tax, and is often the better choice if you expect a much lower bracket in retirement or if the NUA is a small share of the stock’s value.
The strongest candidates are long-tenured employees whose company stock appreciated dramatically over their careers, leaving a basis that might be 10% or less of current market value. For them, paying ordinary income tax (and possibly a 10% penalty) on that thin sliver of basis is a bargain against capital gains treatment on everything above it. Run the numbers on your own basis, appreciation, and expected bracket before you commit, because once you elect out of NUA on the return, the door closes.