Tax Return Reporting for Net Unrealized Appreciation Outline

“In-kind” Transfer: An “in-kind” transfer is a transfer of the exact same thing. In this case, it is a transfer of the exact employer stock owned within the employer plan. Selling that stock and repurchasing it shortly thereafter blows the NUA planning opportunity.

NUA Planning Example

Mark works at Acme Corporation. Inside his Acme retirement account he has $1M worth of Acme stock. He and Acme paid $100,000 for that stock.

Mark is 53 years old and leaves employment at Acme. His NUA opportunity is as follows: he can transfer all his Acme retirement accounts invested in assets other than Acme stock to IRAs (or a new employer’s retirement account) and transfer, in-kind, the Acme stock to a taxable brokerage account (the “NUA distribution”).

Mark creates a $100,000 income hit on this year’s tax return and will owe the 10% early withdrawal penalty (unless he qualifies for an exception) if he does this. However, the $900K of capital gains in that Acme stock gets two big tax benefits. First, it will never be subject to RMDs. Second, when the Acme stock is sold that gain will be taxed at capital gains rates instead of ordinary income tax rates. That is a tremendous advantage to using the NUA strategy.

Does NUA Treatment Make Sense?

NUA does not always make sense when it comes to employer stock in retirement accounts. In fact, in most cases it is likely not to make sense. You saw in Mark’s example there was a real price to pay: ordinary income tax and the possible 10 percent early withdrawal penalty.

What if, instead of paying $100K for the Acme stock over the years, Mark and Acme had paid $700K? There’s no way Mark should use NUA treatment to get $300K of gain into capital gains tax when it would trigger immediate taxation on $700,000 and a $70,000 penalty!

But if the “basis” number is low, being subject to the 0%, 15%, and 20% marginal capital gains tax on the employer stock gain inside the plan can be a great outcome.

NUA treatment has requirements, such as emptying all retirement accounts from the employer in the same year. Thus, oftentimes those with significant amounts of employer stock in a retirement plan should work with professional advisors. For more information on the planning surrounding NUA treatment, read Michael Kitces’ great blog post on the subject.

Tax Return Reporting

Transfer of Employer Stock to Taxable Account

Information Reporting to the Taxpayer and the IRS

First up is the transfer of the employer stock from the workplace retirement plan to a taxable brokerage account (the NUA distribution). This must be an in-kind transfer by the employer plan of the employer stock to the taxable brokerage account. The NUA distribution results in some amount of taxable income. The employer plan issues a Form 1099-R to report the NUA distribution. The Form 1099-R reports the gross distribution amount in Box 1. The taxable amount reported in Box 2a. The Box 2a amount is the amount that the employee and employer contributed to buy the employer stock and is taxable in the year of the NUA distribution. The Net Unrealized Appreciation, the difference between Box 1 and Box 2a, is reported in Box 6. The Net Unrealized Appreciation is the gain that will be subject to long-term capital gains rates in any post-NUA distribution sale of the employer stock.

Reporting on the Taxpayer’s Form 1040

On the individual’s Form 1040 tax return, the gross distribution will be reported on the line for pensions & annuities (line 5a for the tax year 2023 Form 1040), with the taxable amount showing on line 5b.

Now, what about that 10% early withdrawal penalty? There are several exceptions, all of which are reported on Form 5329, Part 1. If, for example, Mark was 55 years old when he left his employment at Acme, qualifies for exception 01 – separation from service distribution in or after the year of reaching 55 (age 50 for qualified public safety employees).

Disposition of Employer Stock

Information Reporting to the Taxpayer and the IRS

These transactions are reported on Form 1099-B. This form will include the number of shares sold, the date they were sold, and the proceeds from the sale.

Reporting on the Taxpayer’s Form 1040

When the employer stock is actually sold, two gains on the sale of that stock must be recognized. The first is the net unrealized appreciation in the employer stock. That amount is crystalized at the time of the NUA distribution from the plan to the taxable account. This gain is always a long-term capital gain, regardless of when the post-distribution sale occurs. The gain is reported by the taxpayer on Form 8949 and Schedule D.

There is a second potential gain. It could be a gain or a loss. It is the amount of the increase (or decrease) in value the stock has experienced since the NUA distribution into the taxable account.

Continuing with Mark’s example, assume the NUA distribution occurred on January 16, 2024. At that time, Mark owned 1,000 Acme shares, each worth $1,000 and each with Net Unrealized Appreciation of $900. On February 20, 2024, Mark sells 40 Acme shares for $1,040 each. This triggers two gains: $36,000 of Net Unrealized Appreciation ($900 NUA times 40), which is taxed as long term capital gain, and $1,600 of short term capital gain ($40 times 40), which is taxed as ordinary income.

Post-NUA Distribution Losses

What if, instead of a post-NUA distribution gain, there’s a loss? The loss simply reduces the NUA recognized on each sale. For example, if Mark’s sale of 40 shares on February 16, 2024 was for $960 per share, the NUA triggered on each share is $860 per share instead of $900 per share.

NUA and the Net Investment Income Tax (Form 8960)

One more form may be required: Form 8960. If the seller’s modified adjusted gross income (“MAGI”) is above $200K (single) or $250K (married filing joint), the gain on top of the NUA ($40 per share in Mark’s example) is subject to the 3.8% net investment income tax. However, the NUA gain itself is not subject to the net investment income tax. See Treas. Reg. Sec. 1.1411-8(b)(4)(ii).

Transfer of Other Employer Plan Assets to IRAs

Information Reporting to the Taxpayer and the IRS

As part of the NUA process, all the other qualified plan assets need to be transferred to a traditional IRA (or Roth IRA if there are Roth qualified plan assets). Assuming this occurs via a direct trustee-to-trustee transfer, it is reported on Form 1099-R with a box 7 code “G” (direct rollover). Box 1 of the 1099-R will indicate the gross distribution, and box 2a, Taxable amount, will be $0, since it’s a direct rollover.

Reporting on the Taxpayer’s Form 1040

On the individual’s tax return, the gross distribution should show up on the line for pensions and annuities (line 5a for the tax year 2023 Form 1040), with $0 showing on line 5b for taxable amount.

Conclusion

For the right situation, NUA is a potentially great tax planning opportunity. For those taking advantage of the opportunity, it is important to get the tax return reporting correct. We leave with one parting thought: those considering NUA are usually well advised to consider working with professional advisors, and those who have implemented an NUA planning process often benefit from working with a professional tax return preparer.

This post is a collaboration by Andrea MacDonald, CPA and Sean Mullaney, CPA.
Follow Sean on X at @SeanMoneyandTax
Follow Andrea on X at @Andreamacdcpa

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, investment, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.