Income and Assets · Retirement income

Taxability of net unrealized appreciation (NUA)

Verification 2026 Verified
tax year · reviewed 2026-08-19 · Draft for I. Ohu review

The treatment turns on a single sentence in IRC § 402(e)(4)(B): on a lump sum distribution that includes employer securities, the appreciation in those securities is excluded from gross income. What is taxed now is only what the trust paid for the shares. The appreciation is taxed later, as capital gain, when the shares are sold — and if they are never sold in the owner’s lifetime, it may never be taxed as ordinary income at all. The whole thing is destroyed by a single ordinary act: rolling the shares into an IRA.

The rule

The exclusion. In the case of any lump sum distribution which includes securities of the employer corporation, there shall be excluded from gross income the net unrealized appreciation attributable to that part of the distribution which consists of employer securities (IRC § 402(e)(4)(B)). The taxpayer may elect, on the return on which the lump sum distribution must be included, not to have the subparagraph apply — which is the only election in the provision. There is nothing to elect into.

What the appreciation is. It is the excess of the market value of the securities at the time of distribution over their cost or other basis to the trust. Where a distribution contains both appreciated and depreciated shares, the figure is the net increase across all of them, and two distributions to the same distributee in one taxable year are treated as one (Reg. § 1.402(a)-1(b)(2)(i)).

What a lump sum distribution is. The distribution or payment, within one taxable year of the recipient, of the balance to the credit of the employee, becoming payable on the employee’s death, after the employee attains age 59½, on separation from service, or after the employee becomes disabled within § 72(m)(7) — from a trust forming part of a § 401(a) plan and exempt under § 501, or from a § 403(a) plan (IRC § 402(e)(4)(D)(i)). Separation from service is available only to a common-law employee; disability only to a self-employed individual within § 401(c)(1).

The balance is measured across plans, not accounts. All trusts in a plan are one trust; all pension plans of the employer are one plan; all profit-sharing plans one plan; all stock bonus plans one plan (IRC § 402(e)(4)(D)(ii)(I)). Leaving a dollar behind in a second profit-sharing plan of the same employer defeats the whole distribution.

Which securities count. Only shares of stock and bonds or debentures issued by a corporation with interest coupons or in registered form (IRC § 402(e)(4)(E)(i)), including securities of a parent or subsidiary corporation as defined in § 424(e) and (f) (§ 402(e)(4)(E)(ii)).

Basis, and the consequence of leaving the appreciation out of it. The excluded appreciation is not included in the distributee’s basis in the securities. Basis is the trust’s cost — the same figure that was taxed as ordinary income in the year of distribution. When the shares are later sold, the excluded appreciation is treated as gain from the sale or exchange of a capital asset held long term, whatever the distributee’s actual holding period; any further gain above that figure is long or short term depending on how long the distributee held the shares (Reg. § 1.402(a)-1(b)(1)(i)).

Outside a lump sum, almost nothing is excluded. On a distribution that is not a lump sum, only the appreciation attributable to amounts contributed by the employee is left out, and even that does not apply where the distribution is rolled over under § 402(c) (IRC § 402(e)(4)(A)).

Current figures

Item	2026
The exclusion	on a lump sum distribution that includes employer securities, the net unrealized appreciation attributable to that part of the distribution is excluded from gross income^TY2026
How it is measured	the excess of the market value of the securities at the time of distribution over their cost or other basis to the trust, taken net across appreciated and depreciated securities, with two distributions in one taxable year treated as one^TY2026
Lump sum distribution	the distribution within one taxable year of the recipient of the balance to the credit of the employee, payable on death, after age 59½, on separation from service, or after disability — from a § 401(a) exempt trust or a § 403(a) plan^TY2026
Balance to the credit	all trusts in a plan are one trust, all pension plans of the employer one plan, all profit-sharing plans one plan, and all stock bonus plans one plan — so the balance must be emptied across the whole category, not just the one account^TY2026
Eligible plans	only a trust forming part of a § 401(a) plan and exempt under § 501, or a § 403(a) plan — no IRA of any kind can produce it, so a rollover of the securities to an IRA ends the opportunity permanently^TY2026
Employer securities	only shares of stock and bonds or debentures issued by a corporation with interest coupons or in registered form, including securities of a parent or subsidiary corporation as defined in IRC § 424(e) and (f)^TY2026
Basis in the shares	the excluded appreciation is not included in the distributee's basis in the securities — basis is the trust's cost, which is the amount taxed as ordinary income in the year of distribution^TY2026
Character on a later sale	on a later sale the excluded appreciation is gain from the sale or exchange of a capital asset held long term, whatever the distributee's actual holding period; any further gain above it is long or short term on the distributee's own holding period^TY2026
The only election	the exclusion applies automatically; the only election is an election not to have it apply, made on the return on which the lump sum distribution is required to be included^TY2026
Outside a lump sum	on a distribution that is not a lump sum, only the net unrealized appreciation attributable to amounts contributed by the employee is left out — and not at all where the distribution is rolled over under IRC § 402(c)^TY2026
Additional tax on early distributions	10 percent of the portion of the distribution includible in gross income, subject to the exceptions in IRC § 72(t)(2)^TY2026

How it works in practice

The sequence at the plan is specific and cannot be reassembled afterwards. The employer securities are distributed in kind to a taxable brokerage account; everything else in the balance goes wherever it is going, including by rollover; and all of it happens within one taxable year of the recipient. The moment the shares themselves are rolled into an IRA, they cease to be a distribution of securities and become an IRA balance — and every dollar of appreciation that would have been capital gain becomes ordinary income on the way out of the IRA. There is no correction for this and no election that recovers it.

The economics are a straightforward comparison and are not always favourable. The cost basis is taxed at ordinary rates now, in a single year, and if the participant is under 59½ it also carries the additional tax on early distributions — measured on the basis, not on the excluded appreciation, because only the basis is includible. Against that, the appreciation escapes ordinary rates and defers until sale. The higher the ratio of appreciation to cost, the better the arithmetic works.

One more feature is easy to overlook: the excluded appreciation is income in respect of a decedent, so the shares get no step-up in basis at death to the extent of it. That is a reason to decide during life, not an argument for holding indefinitely.

Scenario 1 — the two ways to take the same shares

Marisol retires at 61. Her 401(k) holds 800,000 dollars, of which employer stock is worth 300,000 dollars against a trust cost of 45,000 dollars. She distributes the whole balance in one calendar year, taking the shares in kind to a brokerage account and rolling the remaining 500,000 dollars to an IRA.

She includes 45,000 dollars in ordinary income for the year — the trust’s cost. The 255,000 dollars of appreciation is excluded by IRC § 402(e)(4)(B), left out of her basis, and taxed as long-term capital gain only when she sells. Had she instead rolled the shares into the IRA with everything else, she would have reported nothing that year and the entire 300,000 dollars, appreciation included, would have come out as ordinary income later.

Scenario 2 — the dollar left behind

Terrence separates from service and directs his employer to distribute the whole of his profit-sharing plan account, taking employer stock in kind. He forgets a second profit-sharing plan account from an earlier subsidiary of the same employer, holding 1,900 dollars, which stays put.

Under IRC § 402(e)(4)(D)(ii)(I) all profit-sharing plans maintained by the employer are treated as a single plan, so the balance to his credit was not distributed within one taxable year and there is no lump sum distribution. The exclusion in § 402(e)(4)(B) does not apply; the full fair market value of the shares is ordinary income. The 1,900 dollars decided the treatment of the entire distribution.

Scenario 3 — selling in two pieces

Yusuf takes a qualifying distribution of employer shares worth 120,000 dollars against a trust cost of 20,000 dollars, so 100,000 dollars is excluded. Eight months later he sells half the shares for 70,000 dollars; two years after that he sells the rest for 40,000 dollars.

On the first sale his basis is half the trust cost, 10,000 dollars. Of the 60,000 dollars of gain, 50,000 — half the excluded appreciation — is long-term capital gain regardless of his eight-month holding period, and the remaining 10,000 dollars is short-term because that is his actual holding period for the excess (Reg. § 1.402(a)-1(b)(1)(i)). On the second sale, everything is long term: both the allocated appreciation and the gain above it.

There is no election to use this treatment. IRC § 402(e)(4)(B) applies by its own force to a qualifying distribution; the statute’s only election is an election out. A question framed as “electing NUA treatment” has the mechanism backwards.

No IRA can produce it. The lump sum definition reaches a § 401(a) trust and a § 403(a) plan and nothing else. Employer shares sitting in an IRA — however they got there — carry no exclusion.

The additional tax on early distributions falls on the cost, not the appreciation. Only the basis is includible in gross income, so that is the measure; the excluded appreciation is not exposed to it.

Depreciated shares net against appreciated ones in the same distribution (Reg. § 1.402(a)-1(b)(2)(i)) — the figure is net unrealized appreciation, not the sum of the winners.

How this has changed

The statutory text has been stable for decades; the regulation around it has not been conformed. Treas. Reg. § 1.402(a)-1(b)(1)(i) still describes the excluded appreciation, on a subsequent taxable transaction, as “a gain from the sale or exchange of a capital asset held for more than six months.” Six months has not been the long-term holding period since 1976; IRC § 1222 has required more than one year for the whole of the modern era. The regulation’s rule is nonetheless the operative one and its effect is unchanged — the appreciation is long term either way — but the number in the text is wrong, and it is a useful reminder that a live regulation is not the same as a current one.

The same paragraph still refers to the repealed capital gains treatment for total distributions. Its opening cross-references paragraph (a)(6) of the section, the pre-1996 rule under which the whole of a total distribution above employee contributions was capital gain. IRC § 402(e)(5) was repealed in 1996, and only the ten-year averaging transition for participants born before 1936 survived it. Read paragraph (b) for the appreciation rule and ignore what it says about the surrounding regime.

Two provisions widened the definition without changing the exclusion. IRC § 402(e)(4)(D)(v) excludes from the balance to the credit any amount payable to an alternate payee under a qualified domestic relations order, and clause (vii) lets a spouse or former spouse alternate payee have their own lump sum distribution. Neither is intuitive from the operative sentence, and both change who can qualify.

Exam focus

Expect the destroyed opportunity to be the tested point: a fact pattern where the shares are rolled into an IRA and the question asks what treatment is available. The answer is none, and it cannot be restored.

Expect the balance to the credit aggregation. Any residual left in a plan of the same category defeats the lump sum, and the facts will usually mention the leftover account in passing.

Expect the character question, in two parts: the appreciation is long term whatever the holding period, and only the excess over it follows the distributee’s own period.

Do not read the provision as an election in. And check the plan type before anything else — a § 401(a) trust or a § 403(a) plan qualifies; a § 403(b) arrangement, a § 457(b) plan and every IRA do not.

Check yourself

1. A participant takes a qualifying lump sum distribution including employer stock worth 90,000 dollars that cost the trust 15,000 dollars. What is included in gross income for the year?

Answer: 15,000 dollars, the trust’s cost. The 75,000 dollars of net unrealized appreciation is excluded from gross income by IRC § 402(e)(4)(B) and is not included in the distributee’s basis.

2. The same participant is 52 years old. What is the additional tax on early distributions measured on?

Answer: The 15,000 dollars actually included in gross income. The excluded appreciation is not includible, so it is not part of the measure.

3. Six weeks after the distribution the participant sells all the shares for 96,000 dollars. How is the 81,000 dollars of gain characterised?

Answer: 75,000 dollars is long-term capital gain notwithstanding the six-week holding period, and the remaining 6,000 dollars is short-term because it exceeds the excluded appreciation and follows the distributee’s own holding period (Reg. § 1.402(a)-1(b)(1)(i)).

4. A client rolled employer shares from a 401(k) into a traditional IRA in 2024 and now asks to use this treatment on them. Can she?

Answer: No. IRC § 402(e)(4)(D)(i) confines a lump sum distribution to a § 401(a) exempt trust or a § 403(a) plan, so an IRA cannot produce the exclusion, and the appreciation will be ordinary income when distributed from the IRA.

5. Is the exclusion something the taxpayer elects?

Answer: No. It applies automatically to a qualifying distribution. The second sentence of IRC § 402(e)(4)(B) provides only an election not to have it apply, made on the return on which the lump sum distribution must be included.

Change log

2026-08-19Initial draft. Sets out the IRC § 402(e)(4)(B) exclusion of net unrealized appreciation on a lump sum distribution of employer securities, the § 402(e)(4)(D) definition of a lump sum distribution and its aggregation rule, the Treas. Reg. § 1.402(a)-1(b) computation and basis consequence, and the long-term character on a later sale. Records that the governing regulation still measures long term as more than six months.