How to Report NUA on a Tax Return

The Net Unrealized Appreciation (NUA) strategy can offer significant tax savings for clients with highly appreciated company stock in their retirement plans, but correctly reporting it is anything but simple. Getting it wrong can invalidate the entire strategy, and navigating the two-step reporting process requires careful attention to detail. This guide provides a clear-cut walkthrough for reporting the initial NUA distribution and the eventual sale of the shares, ensuring you can guide your clients with confidence.

What Exactly is Net Unrealized Appreciation (NUA)?

Net Unrealized Appreciation refers to the increase in value of your client's employer stock from the time it was acquired in their retirement plan to the time it's distributed. Instead of rolling these shares into an IRA and deferring tax at ordinary income rates on the entire amount, the NUA rule allows for preferential tax treatment.

Here’s the core benefit: your client can take an in-kind distribution of a lump sum of company stock from a qualified plan (like a 401(k) or ESOP) to a taxable brokerage account. Upon distribution, they pay ordinary income tax only on the stock's original cost basis. The NUA—the growth in value—is not taxed until the client actually sells the shares. When they do sell, that NUA portion is taxed at favorable long-term capital gains rates, regardless of how long they've held the shares post-distribution.

To qualify for NUA treatment, the distribution must meet specific requirements:

• Lump-Sum Distribution: The client must distribute their entire vested account balance from all qualified plans of a similar type (e.g., all 401(k) plans) from that employer within a single tax year.
• In-Kind Transfer: The shares must be moved directly to a taxable brokerage account, not an IRA. Any non-stock plan assets can be rolled into an IRA.
• Triggering Event: The distribution must follow a triggering event, such as separation from service, reaching age 59½, death, or disability.

Two-Step Reporting: The Initial Distribution and the Final Sale

Reporting NUA isn't a one-time event. It involves two distinct taxable events: the first when the stock is distributed from the plan and the second when the shares are eventually sold from the brokerage account. Each step has its own set of reporting rules and forms.

Let's use an example we can follow through both steps:

Your client, Sarah, separates from her company at age 60. She has 1,000 shares of company stock in her 401(k). The original cost basis for these shares (what the plan paid for them) is $50,000. On the day of her lump-sum distribution, the Fair Market Value (FMV) of the shares is $200,000.

• Cost Basis: $50,000
• Fair Market Value (FMV): $200,000
• Net Unrealized Appreciation (NUA): $150,000 ($200,000 FMV - $50,000 Cost Basis)

Step 1: Reporting the Lump-Sum Distribution (The Year of the Event)

Immediately after the distribution, the plan administrator will issue Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. This form is the key to accurately report the initial transaction on your client's tax return.

Here’s how the details of Sarah's distribution would appear on her Form 1099-R:

• Box 1, Gross distribution: $200,000 (The full Fair Market Value of the shares on the distribution date).
• Box 2a, Taxable amount: $50,000 (The cost basis, which is subject to ordinary income tax in the current year).
• Box 6, Net unrealized appreciation in employer's securities: $150,000 (The amount of gain that is being deferred).
• Box 7, Distribution code: This will contain a code indicating the reason for the distribution. Since Sarah is over 59½ and separated from service, it would likely be Code '7' (Normal distribution).

To report this on your client's tax return, you transfer the information from Form 1099-R to Form 1040:

1. On Form 1040, line 5a (Pensions and annuities), enter the gross distribution from Box 1 of the 1099-R. For Sarah, this is $200,000.
2. On Form 1040, line 5b (Taxable amount), enter the taxable amount from Box 2a of the 1099-R. For Sarah, this is $50,000.

The IRS's system automatically recognizes that the difference between line 5a and 5b ($150,000 for Sarah) represents the deferred NUA. Your client pays ordinary income tax on the $50,000 cost basis this year, and tax on the NUA is deferred until the shares are sold.

Step 2: Reporting the Subsequent Sale of Shares (The Future Event)

Years later, Sarah decides to sell some of her company stock. Let's say she sells 200 shares (20% of her total shares) when the price has risen. The sale nets her $60,000.

Here’s how you calculate and report the gain. This is where meticulous record-keeping and understanding of basis becomes vital.

1. Calculate the Basis and the Gains

First, determine the cost basis for the shares she sold. Her original cost basis was $50,000 for 1,000 shares, so the per-share basis is $50. For the 200 shares she sold, the cost basis is:

Cost Basis = 200 shares * $50/share = $10,000

Now, break down the gain into its two components: the NUA portion and any additional market appreciation.

• NUA Portion: Sarah's NUA per share was $150 ($150,000 / 1,000 shares). For the 200 shares sold, the NUA is $30,000 ($150 * 200). This part is always treated as a long-term capital gain.
• Post-Distribution Appreciation: The total gain on the sale is $50,000 ($60,000 sale price - $10,000 basis). Subtracting the NUA gives us the additional gain since the distribution: $50,000 total gain - $30,000 NUA = $20,000. This gain's character (short-term vs. long-term) depends on how long Sarah held the shares after the distribution date. If she held them for more than one year, this $20,000 is also a long-term capital gain. If she'd sold within a year, it would be a short-term capital gain.

2. Report the Sale on Form 8949 and Schedule D

This is where practitioners add tremendous value, as broker-issued Form 1099-Bs are often incorrect for NUA sales. The brokerage firm may mistakenly report the cost basis as the stock's FMV on the distribution date (e.g., $40,000 for the 200 shares in our example), not the true plan-level cost basis ($10,000).

If the brokerage reports an incorrect basis, you will use Form 8949, Sales and Other Dispositions of Capital Assets, to correct it:

1. For the NUA Portion: On one line of Form 8949, Part II (for long-term gains), check box (F) because this is a long-term transaction where you need to make an adjustment. Report the sale proceeds and the incorrect basis from the broker's 1099-B. In column (g), enter adjustment code B (incorrect basis). In column (h), enter the negative adjustment needed to get from the broker's reported basis to your correct, lower basis. This will result in the correct total gain of $50,000.
2. For the Post-Distribution Appreciation: If this portion is short-term, you’d report it on a separate line in Part I of Form 8949.

Here’s a simpler method if the 1099-B doesn’t specify a basis. You would report on format 8949 as follows:

• (a) Description of property: 200 shares of XYZ Corp
• (d) Proceeds: $60,000
• (e) Cost or other basis: $10,000
• (h) Gain or (loss): $50,000

The total capital gain of $50,000 is considered long-term. The reconciled gain from Form 8949 then flows to Schedule D (Form 1040), Capital Gains and Losses.

Key Pitfalls and Client Reminders

This strategy is powerful, but easy to derail. Keep your clients aware of these potential mistakes:

• Incorrect 1099-B Basis: Remind clients to provide you with the original 1099-R from the year of distribution. You will need it to verify the true cost basis when they start selling shares, potentially decades later. Never rely solely on the brokerage 1099-B for NUA stock.
• Violating the Lump-Sum Rule: If a client forgets about an old ESOP or an old 401(k) with the same company and doesn't distribute it in the same year, the NUA treatment for all shares can be voided.
• Accidental IRA Rollover: Drilling this point home is vital. The shares *must* go to a taxable brokerage account. If they touch an IRA, the NUA disappears forever, and all future withdrawals will be taxed at higher ordinary income rates.
• Donating and Inheriting NUA Shares: Counsel clients on future planning. If they donate NUA shares to charity, no one ever pays tax on the capital gains. If an heir inherits them, they receive a step-up in basis on the post-distribution appreciation, but they will still pay long-term capital gains tax on the original NUA when they sell.

Final Thoughts

Reporting on Net Unrealized Appreciation is a two-part process that demands documentation and diligence, first upon distribution and again at each subsequent sale. By carefully tracking the original cost basis from the plan, correcting brokerage forms when needed, and accurately reporting gains, you can fully execute this valuable tax-saving strategy for your clients.

When clients come to you with complex situations like NUA distributions, you need quick, definitive answers. Instead of spending hours hunting through IRS publications for niche rules, you can use a tool like Feather AI to get instant, accurate answers backed by Internal Revenue Code citations. This helps us spend more time on strategy and less on manual research, ensuring our clients receive the best possible advice.