Anyone who owns company stock in a 401K plan will eventually have to decide how to distribute those assets—typically when you retire or change employers. Taking a distribution could leave you facing a big tax bill, but a little-known tax break—taking advantage of net unrealized appreciation (NUA)—has the potential to help.
NUA is a little-known tax strategy that allows 401K participants to choose between ordinary income tax and capital gains tax on their stock positions. With the help of a financial planner, your tax can be minimized for the short term or the long-term plan. There are few requirements to use this strategy and generally a clear understanding of your numbers will be essential in deciding which is the best approach for you.
In order to get started you will need these pieces of information:
- Cost basis of company stock - This is usually shown as an average share price
- Fair market value of company stock
- NUA - The difference between the current value and your basis
- Current and expected future tax rate
The strategy is typically executed at a trigger point. The allowable trigger points are separation from service, turning 59.5, disability, and death. When a trigger point is prompted a participant will be faced with several choices. They can rollover their 401K including the company stock to an IRA or another employer plan. This will preserve the tax deferral on the funds. At withdrawal, they will need to pay income tax on any amounts withdrawn. The second choice available will be to execute NUA. Instead of a rollover the company stocks are transferred in kind to a non-retirement account. The tax treatment will be ordinary income tax on the basis and long-term capital gains tax on the NUA. Any funds not invested in the company stock will be rolled over with the tax deferral treatment.
Now we compare the two scenarios:
Rollover Scenario
Example Company Stock $100,000. Your fed tax rate is 22% and your state tax rate is 5%.
If you do the rollover and subsequently withdraw the funds, you will pay 27% ordinary income taxes. Or a total tax of $27,000.
NUA Scenario
Example Company Stock $100,000 Fair Market Value
Cost Basis 20,000, Your fed tax rate is 22% your state tax rate is 5%. The Long Term Capital Gains tax rate 15%
If you do NUA, the company stock is transferred in kind to a non-retirement account. Taxes due at the transfer date would be 27% ordinary income taxes on the basis and 15% long-term capital gain taxes on the NUA at sale. That translates to $5,400 in income taxes immediately. An additional capital gain tax of $12,000 at the sale of the stock. Total tax for $17,400.
There is a large immediate tax saving at the example’s income levels. The tax savings becomes larger at higher incomes and tax rates. Most participants will find significant and similar savings on company stock positions held over the course of several decades. This is an extremely valuable long-term strategy that can be used to reduce your taxes. It also helps reduce your future required minimum distributions because it removes the company stock from your rollover IRA.
It is important to review each unique financial situation for those who are close to retirement, in order to determine if the NUA option is the right decision for them. Speaking with a financial planner will help you determine whether you can execute NUA and how much savings you will receive from the strategy. It's important to plan for this move early as there are ways to derail the maneuver. The most common mistake is trading the company stock,which will reset your cost basis. This will erode your savings as it reduces your total stock position. If you buy the company shares back it will increase your average share price.
In conclusion, the wealth-building process is an ongoing endeavor. Thoroughly review your options in terms of your company benefits, investment options, and tax strategies in order to create a holistic plan. Make sure to review your options and your situation with a financial planner.
