When a participant holds appreciated employer stock inside a 401(k) or other qualified plan, there is a strategy that can convert what would be ordinary income on an IRA rollover into long-term capital gain: the net unrealized appreciation (NUA) distribution. Instead of rolling the entire account to an IRA - where all future distributions are taxed as ordinary income - the participant takes a lump-sum distribution of the employer stock in-kind. The cost basis is taxed as ordinary income. The NUA - the appreciation inside the plan - is taxed as long-term capital gain when the stock is eventually sold, regardless of how long the stock is held after distribution.
Without NUA strategy: Roll 401(k) (including company stock) to IRA. All future distributions taxed as ordinary income at your marginal rate - including the appreciation on company stock that built up inside the plan over decades.
With NUA strategy: Take a lump-sum distribution of the employer stock in-kind. Pay ordinary income tax on the cost basis (what the plan paid for the shares). The NUA - everything above that cost basis - is taxed at long-term capital gains rates (0%, 15%, or 20%) when you eventually sell. No ordinary income on the NUA regardless of holding period after distribution.
IRC §402(e)(4) requires all of the following: (1) a lump-sum distribution - the entire account balance from all plans of the same type must be distributed in a single tax year; (2) from a qualified plan (401(k), profit-sharing, pension - not IRAs); (3) after a triggering event - separation from service, reaching age 59½, death, or disability; and (4) the distribution includes employer securities (company stock held inside the plan). All four must be present. A partial distribution or a distribution from only some of the plans does not qualify.
NUA is most valuable when: the cost basis inside the plan is low relative to the current value (large NUA), the participant is in a high ordinary income bracket (so the IRA rollover would be taxed at 37%), and long-term capital gains rates (20% + 3.8% NIIT at high incomes) are meaningfully lower than the marginal ordinary income rate. The math typically favors NUA when cost basis is less than 30-40% of current value. When cost basis is high - meaning the stock has not appreciated much inside the plan - the benefit is minimal and the complexity is not worth it.
In a lump-sum distribution that qualifies for NUA, only the employer stock gets the NUA benefit. All other assets - cash, mutual funds, bonds - are rolled to an IRA to defer tax. The stock is taken in-kind (actual shares, not cash) and moved to a taxable brokerage account. The employer reports the distribution on Form 1099-R with the cost basis in Box 6 (NUA amount) and Box 2a (taxable amount = cost basis only).