NUA + Capital Gain Harvesting: A Powerful Combo

I had a client recently semi-retire (wife still has some self-employment income) with a sizeable 401(k) filled to the brim with employer stock. He had nearly $1m of employer stock in that account for which he only paid ~$25k! This got me thinking — here’s potentially an excellent candidate for an net unrealized appreciation election i.e. an NUA election.

If you’re unfamiliar with NUA, here’s how it works. If you have employer stock in a qualified retirement plan, you can elect to pay income taxes on what you paid for the employer stock i.e. the “basis” and pay long-term capital gains on the everything else, i.e. the net unrealized appreciation. Contrast this with the standard tax treatment of qualified retirement plans which simply says you pay income taxes on ALL distributions. If your capital gains rate in retirement is lower than your income tax rate in retirement (not guaranteed), then there’s a tax arbitrage you can take advantage of.

Any IRS provision offering tax payers a break always come with hurdles and caveats of course and NUA is no exception. For starters, you must have a qualifying event of which there are 4: separation from service, reaching age 59.5, death, or disability.

Next, the distribution you take MUST be a full distribution. You cannot make a partial distribution. This means that all employer stock and any non-employer stock must leave the plan in the same year. If you do not successfully distribute the entire account, you lose access to the NUA election for that qualifying event, although you may use it for future qualifying events e.g. if you screw it up for the separation of service qualifying event, you can try again when you reach 59.5.

Next, all employer stock on which you are electing NUA must go to a taxable brokerage account. The rest, including employer stock on which you do not elect NUA will rollover to an IRA. It’s important to note that while you must make a full distribution in the year you elect NUA, you are not required to elect NUA on all employer stock. For example, in the case of my client from the first paragraph, I eventually recommended he elect NUA on half of the employer stock for reasons I’ll highlight in a minute.

Next, only the NUA i.e. the gain you distribute from your plan, immediately qualifies for long-term capital gains treatment. Any future gain will still have the standard 1 year waiting period before long-term capital gains treatment applies. Here’s an example — You have $10 of employer stock for which you paid $2 in a 401k (using small numbers for ease of understanding). Your basis is $2 and your NUA is $8 i.e. you will pay income taxes on $2 and will immediately qualifying for long-term capital gains treatment on the $8. Now, let’s say after the NUA election you decide not to immediately sell your $10 employer stock and it grows to $12; that extra $2 of growth will not receive long-term capital gains treatment until at least 1 year from your distribution.

The last two caveats I will mention, although there are others that are less important the point of this article, is your NUA loses the step up in cost basis treatment at your death. This means, the gain that you distributed from your retirement plan i.e. amounts above your basis, will not be stepped up at your death. Any gains over this amount will be stepped up, it’s just that original NUA component that loses the step up.

Using the same example as above, if you have $10 worth of employer stock in your plan for which you paid $2 — that $8 difference is your NUA. Once you distribute the account, your employer stock may grow to $12 — that subsequent $2 of growth will get the step up in cost basis.

Lastly, if electing NUA before age 59.5 and in the absence of any exception (e.g. the Rule of 55), your basis could be subject to an additional 10% penalty along with income taxes.

Back to my client — since he had such a massive gain and a massive amount of employer stock relative to his other assets, we certainly wanted to take advantage of NUA but we didn’t want to put his plan in jeopardy by having too much of his wealth concentrated in his employer stock. If we had elected NUA on the entire amount, we would be in the uncomfortable position of hoping the stock doesn’t crash while we spend it down over a number of years. We wouldn’t be able to immediately diversify the concentrated position without realizing a ton of capital gains.

By instead electing NUA on half the position, we could still get some of the tax benefits of paying long-term capital gains tax on the majority of the account while not putting his retirement in jeopardy if the company has a serious issue. Since we are electing NUA on only half of the employer stock, the other half will end up in an IRA where it can then be safely diversified without creating a tax headache.

Here’s where it gets cool — last year, this client had about $95k in total income, taxable income of about $45k. Next year with the NUA election, but without realizing any gains, they will base income of only ~38k in total income and taxable income of $0.

There is a 0% long-term capital gains tax rate up to $98,900 in taxable income in 2026.

This means they can realize ~$97k in gains without paying a single extra penny in taxes! The following year that number rises to ~$111k in gains!

The equivalent amount of ordinary income via IRA distributions would have resulted in $10k in extra taxes in the next year alone!

Now, they of course won’t need $97k in extra gains. They already have a small amount of social security and schedule C income, so they will only need perhaps $50k to $60k of those gains for living expenses. The other $37k-$47k in realized gains can simply be reinvested in a more diversified way. The basis on which their future gains will be calculated will now be much higher so that if they do need to fully distribute the account, the resulting tax hit will be lower.

This is a key feature of capital gains harvesting that is sometimes misunderstood due to rules surround realized losses designed to prevent wash sales. Wash sale rules do not apply to gains. There is nothing to prevent someone from realizing gains in the 0% long-term capital gains tax bracket in order to reduce the amount of gains that end up in the 15% long-term capital gains tax bracket.

For this couple, they are in the perfect position to realize and live off these capital gains in the 0% tax bracket for the next few years. This should give them plenty of time to fully sell off the employer stock and save them tens of thousands in taxes. Not only do they get to take advantage of capital gains harvesting in this situation but they will also be reducing future RMDs (since the employer stock doesn’t end up in an IRA).

With careful analysis paring an NUA election with capital gains harvesting can be a powerful tax reduction strategy in retirement.