Do you have company stock in your 401(k) plan? Net Unrealized Appreciation rules could save you thousands in taxes. NUA rules allow you to withdraw company stock from your plan and pay lower capital gains tax rates on the gains, instead of ordinary income rates normally paid on 401k withdrawals.
But the strategy isn’t for everyone. The cost basis of the stock must be reported immediately as income upon withdrawal. So those with relatively small gains benefit less than those with large gains.
In addition, the strategy can become problematic for those whose company stock represents a significant portion of their nest egg. If their desire is to liquidate the entire position and diversify immediately, they may be pushed into higher capital gains rates (potentially even higher than the rates they would have paid on withdrawals from the 401k in retirement).
For these reasons, the viability of this strategy requires a careful analysis of the tax implications, both today and in the future, weighed against the need for and urgency of diversification.
Net Unrealized Appreciation (NUA) Explained
When an investor retires, he typically has two options for his 401(k) account – he can leave it with his current employer plan (if the plan allows it) or he can roll it to an Individual Retirement Account (IRA). Either of these two options keeps the accounts in a tax-deferred status. No taxes will be paid on the account until withdrawn for retirement spending.
A third option, though rarely recommended, would be to cash out the 401(k) and pay taxes on the entire amount. The reason that this strategy is so unappealing is that withdrawals from a 401(k) are taxed at ordinary income rates. So, if you have a significant portfolio, you could be pushed into the highest tax brackets by taking a lump sum withdrawal.
To get the most tax benefit from retirement accounts, you want to keep the gains deferred as long as possible – typically only withdrawing funds as needed for spending. By doing so, you keep yourself in a relatively low tax bracket in retirement.
Here’s where Net Unrealized Appreciation comes in. This rule allows those who hold company stock inside their 401k to withdraw the stock from the account and pay favorable capital gains rates on any embedded gains, instead of ordinary income rates normally incurred on 401(k) withdrawals.
For example, let’s say you have $1,000,000 in your 401(k) and $100,000 of that balance is company stock. And let’s say your cost basis in the stock is $20,000. What the NUA rules allow you to do is to withdraw the stock from your 401k upon retirement and only pay ordinary income taxes on the $20,000 cost basis. The $80,000 gain in the stock is taxed at lower capital gains rates. If you are in the 24% income tax bracket and 15% capital gains bracket, you essentially just saved yourself $7,200!
3 NUA Rules to Remember
- You must transfer the stock in-kind. In order to maintain the favorable tax treatment, your 401(k) must distribute the stock in-kind. In other words, you can’t sell the stock in the 401(k) and distributed cash.
- You must make a lump sum distribution. This means that at the time you withdraw the employer stock from your account, you must also transfer the rest of the 401(k) balance. This doesn’t mean you have to take a full withdrawal of the 401(k) balance (which would result in a huge tax bill). Instead, you may designate where the remainder of the account should be distributed. If it they are pre-tax dollars, you would likely roll them to a Rollover IRA. If they are Roth dollars, then roll to a Roth IRA.
- Distribution must be done after a triggering event. The IRS has specified 4 triggering events that qualify you for the NUA treatment:
- Separation from service
- Reaching age 59 ½
For most, this means that the best time to implement this strategy will be upon retirement.
Who Benefits the Most from NUA Rules?
Those with very low cost basis (helps to have a record of specific tax lots)
The main concept of this strategy revolves around converting your dollars from ordinary income to capital gains. The more gain you have in the position, the more valuable this strategy is. For example, going back to our example above, if your basis in the stock was $80,000, instead of $20,000, then you’ll have to pay ordinary income taxes on $80,000 in the year you take the distribution. The small savings you get on the remaining $20,000 gain may not be worth the extra tax-deferral you get by leaving the stock in an IRA.
One thing to note here is that having a record of your stock purchases can be extremely valuable in this situation. Since the IRS does not require you withdraw all of the company stock, for those that do have good records, a good option may be to rollover the higher basis stock to an IRA, and only withdraw the lowest basis stock.
For example, let’s say for sake of simplicity, of the $100,000 you have in company stock, $50,000 of it has a cost basis of $10,000, while the other $50,000 was just recently purchased, and has a basis of $50,000. If you have proper records, you could withdraw the $50,000 with the low basis, converting $40,000 to capital gains treatment, and roll the other $50,000 to your IRA.
Those who don’t have urgency to sell
One wrinkly to the NUA strategy is that you are not required to sell the stock immediately when it is distributed. You are required to pay ordinary income taxes on the basis in the year you make the withdrawal, but you are allowed to keep the stock indefinitely and delay paying taxes on the capital gain.
The reason this is so important is that you can potentially combine the benefit of a lower tax rate with the power of tax-deferral by delaying selling the stock. What’s more, for those who wish to hold the stock indefinitely, they can potentially avoid paying tax altogether by leaving the stock to heirs, who will receive a step-up in basis at your passing.
Of course, I always recommend proper diversification. And if company stock makes up a significant portion of your nest egg, you absolutely should diversify. However, if the stock makes up a relatively small piece of your portfolio, and you would like to hold onto some of it, then the NUA strategy can be even more powerful.
Early retirees can potentially benefit from NUA rules even more than others for a couple reasons. First, early retirees often have structured finances in such a way that they will be in very low tax brackets in the first few years of retirement. If this is the case, you may be able to offload your company stock tax-free (capital gains are taxed at 0% for income below $39,375 in 2019). Low-tax years
The second reason early retirees can benefit is that the 10% early withdrawal penalty that is normally applied to retirement withdrawals before age 59 ½ only applies to the cost basis of the company stock. So again, going back to our example, if your $100,000 company stock has a basis of $20,000, you would only pay the 10% penalty on the $20,000, instead of on the entire $100,000 withdrawal. This benefit can be extremely powerful if you are retiring quite young, have a large company stock position and very low basis.
Proceed with Caution
Given the various considerations and moving pieces, I highly recommend consulting with your financial advisor or CPA before proceeding with an NUA distribution. This strategy is certainly not for everyone. However, it can represent a significant tax savings if done properly and in the right situation.
If you’d like help analyzing your situation to understand if an NUA distribution is right for you, you can email me at firstname.lastname@example.org, call 801-753-8538 or schedule a complimentary, no-obligation introduction here.