Optimizing IRA Rollovers with NUA: Turn Employer Stock into Tax Alpha

While most of my conversations with investors and advisors are about concentrated stock positions in taxable accounts, occasionally someone will say: “Wow, the exchange fund is a great solution. I wish there were something similar for retirement accounts.”

The good news is that concentration risk inside a retirement account can be eliminated immediately without triggering a tax bill. Taking a distribution, however, results in taxable income at ordinary rates.

When you leave your company or reach age 59½, you can roll your 401(k) into an IRA and continue deferring taxes until required minimum distributions (RMDs) begin at age 73. The conventional planning approach is to delay withdrawals for as long as possible. However, eventually, every dollar distributed is taxed as ordinary income, and any remaining balance at death is taxable to the heirs.

But what if a portion of your retirement account could be treated differently with capital gains treatment, lifetime deferral, and even a potential step-up in basis?

That’s where a little-known provision of the tax code comes in. Under Section 402(e)(4) of the Internal Revenue Code, employer stock held in a 401(k), ESOP, or pension plan may qualify for Net Unrealized Appreciation (NUA) treatment. This rule allows part of your retirement account to be taxed at favorable long-term capital gains rates instead of higher ordinary income rates.

If you’ve spent 20+ years at a single company, chances are you’ve built up a large employer stock position inside your retirement plan. In this article, we’ll explain how NUA works and who qualifies, break down the federal tax rules, and review important state-level considerations. From there, we’ll highlight how pairing NUA with exchange funds can turn concentrated stock into a diversified portfolio without losing favorable tax treatment. Finally, we’ll walk through a Costco executive case study, comparing three retirement scenarios side by side.

NUA Explained: How Employer Stock Gets Special Tax Treatment

NUA applies to employer stock held inside a qualified retirement plan. The core idea is straightforward, but execution is governed by strict rules:

• The Cost basis of employer stock is taxed immediately as ordinary income in the year of distribution.
• The NUA portion—the appreciation that accrued inside the plan—is deferred until you sell and taxed at federal long-term capital gains rates, even if sold immediately.
• Any post-distribution growth is taxed as capital gains (short- or long-term, depending on holding period after distribution).

Who Qualifies for NUA and How It Works

All conditions must be satisfied to take advantage of NUA benefits. Missing one disqualifies the treatment:

1. Triggering event: Retirement, separation from service, reaching age 59½, disability (certain plans), or death.
2. Lump-sum distribution: The entire balance of that employer’s plan must be distributed in a single tax year.
3. In-kind distribution: Employer stock must be transferred as shares, not sold inside the plan.
4. IRA rollover for other assets: Non-stock assets can be rolled into an IRA without affecting NUA eligibility.

👉 Tip: If you separate at age 55 or later, you may avoid the 10% early withdrawal penalty on the cost-basis portion.

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State Tax Considerations

While federal law provides meaningful savings, state rules vary. Most states conform to federal timing (no tax until the appreciation is sold) but not federal rate treatment. In those states, capital gains are taxed as ordinary income, eliminating the advantage.

California is a clear example. The state allows you to defer tax on the NUA portion until the eventual sale but does not offer preferential capital gains rates. Instead, gains are taxed as ordinary income at rates up to 13.3%, the highest in the country. For high-tax states, the benefit of NUA is primarily tax deferral, and careful modeling is essential to determine net value.

Enhancing NUA Benefits with an Exchange Fund

NUA can significantly improve federal tax treatment by converting part of your retirement account into long-term capital gains. But on its own, NUA doesn’t solve the problem of concentration risk. Exchange funds bridge that gap.

• Investors contribute appreciated stock into a pooled partnership and receive a diversified portfolio interest in return.
• Contributions are a non-recognition event under IRC §721—no tax triggered, basis carries over.
• When stock is contributed after an NUA distribution, the basis and appreciation split is preserved inside the fund.

This sequence—NUA first, exchange fund second—allows immediate diversification without losing favorable federal tax treatment, helping reduce both long-term tax costs and portfolio risk.

👉 Read our Comprehensive Exchange Fund Guide

Case Study: Meet David, VP of Operations at Costco

David has spent more than 30 years helping his company grow and scale into the global leader it is today. Along the way, he steadily built up his retirement savings in the company’s 401(k) plan. Like many long-tenured executives, his account has grown large and heavily concentrated in Costco stock.

David is beginning to think about retirement. His goals are clear: he wants his retirement account to continue growing, preserve as much tax deferral as possible, and reduce his exposure to a single company’s stock. He doesn’t expect to need liquidity for at least the next 10 years, giving him the flexibility to pursue strategies that optimize for long-term tax treatment.

David’s Challenges

• Concentration risk: Over half of his retirement account is in Costco shares, leaving him exposed to a single stock’s volatility.
• Tax efficiency: Any distribution from his 401(k) is normally taxed as ordinary income, potentially creating a giant tax bill.
• Diversification: He wants to rebalance into a broader portfolio without triggering unnecessary taxes.

Planning Scenarios

David sat down with his financial advisor to map out his options. His advisor explained the Net Unrealized Appreciation (NUA) rules and how they could apply to his Costco shares. Together, they modeled three different scenarios to compare the long-term outcomes.

• Scenario A: Roll the entire balance into an IRA, deferring tax until withdrawals begin at age 75.
• Scenario B: Apply NUA to the Costco stock, move it into an exchange fund, and pay capital gains when liquidating at age 75.
• Scenario C: Apply NUA and move the Costco stock into an exchange fund that qualifies for a full step-up in basis at death, effectively eliminating capital gains on that portion.

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Results

By pursuing the NUA strategy and contributing his Costco stock to an exchange fund, David can diversify immediately and preserve favorable federal tax treatment. The strategy could save him an estimated $510k after tax compared to a traditional rollover, while also reducing concentration risk. If the exchange fund qualifies for a full step-up in basis, the benefit could grow to nearly $1.92M more than a full rollover by age 73, and even higher at full life expectancy.

Key Planning Takeaways

• ✅ NUA allows you to convert part of your 401(k) into capital gains treatment federally.
• ✅ Combining NUA with an Exchange Fund diversifies a concentrated stock position while preserving federal NUA benefits.
• ⚠️ Must follow NUA rules strictly (triggering event, lump-sum distribution, in-kind transfer).
• ⚠️ Exchange funds require long lockups (often 7 years) and accredited investor status.

Should You Consider an NUA Rollover?

NUA can be a powerful planning tool, but it’s not the right move for everyone. Before pursuing this strategy, it’s worth weighing the following considerations with your advisor:

• % Gain on Employer Stock: The larger the gain, the greater the potential benefit.
• Flexibility: Without an exchange fund, any sale after NUA triggers capital gains.
• Exchange Fund Eligibility: Not all employer stock qualifies. Funds typically require large-cap, publicly traded stock and minimum contribution levels.
• Liquidity Needs: Best suited for long-term holders without near-term cash needs.
• Concentration Risk Pre-Rollover: Waiting for NUA eligibility leaves you exposed to employer stock volatility.

Conclusion

NUA planning can be a powerful way to optimize retirement distributions, especially for executives or long-tenured employees with significant holdings of employer stock. By combining NUA tax treatment with an exchange fund, it’s possible to both unlock federal capital gains treatment and diversify away from concentration risk—two of the most pressing challenges facing retirement investors today.

Every situation is unique, and the rules are complex. But if you’ve built up a large position in company stock within your 401(k), the potential benefits are too significant to overlook.

Next Steps

If you’d like to explore whether an exchange fund could be the right fit for your portfolio, or a solution to bring forward in client conversations, learn more about managing concentrated stock with exchange funds:

👉 How do exchange funds work? The ultimate guide

Disclaimer

This content is for educational purposes only. It is not tax, legal, or investment advice. Please consult with your CPA, attorney, and financial advisor before making any decisions.

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