Net Unrealized Appreciation: An Overlooked Option

If you own shares of employer stock in a 401(k), ESOP, or other qualified retirement plan and are planning to retire soon or take a lump-sum distribution, then net unrealized appreciation (NUA) may represent a tax planning opportunity for you.

NUA is the difference between what you paid for the employer stock (cost basis) and its value at the time of distribution. In general terms this is known as the gain or growth of the stock. When you are ready to roll over your 401(k) containing employer stock, you have two options: roll the entire amount to an IRA or transfer the employer stock to a taxable account and roll the value of the other holdings to an IRA.

With option one, the employer stock is rolled over in kind while the other assets are liquidated and then deposited as cash in the rollover IRA. No taxes are incurred at rollover, but every withdrawal is subject to tax at your ordinary income tax rate, including the gains on the employer stock.

Option 1: Traditional 401(k) Rollover

With option two, the NUA strategy, employer stock is transferred in-kind to a taxable account while the other holdings are liquidated and rolled over to an IRA within the same calendar year. The cost basis of the employer stock is subject to tax at your ordinary income tax rate when the transfer occurs. The NUA portion (or growth) is subject to long-term capital gains rates if you sell. Any growth incurred on the employer stock after it is transferred in-kind to a taxable account is also subject to applicable capital gains tax if sold.

Option 2: Utilizing NUA

Suppose you have $100,000 of employer stock in your 401(k) with a cost basis of $20,000. That means there is $80,000 of growth (NUA). Review the tables below to see how the two options impact total tax.

The tax savings using the NUA strategy range from $5,600 to $17,600 depending on your tax bracket.

Benefits of the NUA Strategy

• Growth is subject to capital gains tax instead of ordinary income tax.
• It reduces required minimum distribution (RMD) amounts when you reach age 72 because the assets are not in an IRA.
• The step-up in cost basis upon death relieves some tax burden for your beneficiaries.

How do I take advantage of NUA?

Three requirements must be met:

• You must take an in-kind distribution of the company stock from the 401(k) plan to a taxable account. This means the stock is transferred without being sold.
• You must take a lump sum distribution of the remaining 401(k) account balance within the calendar year. The value of the 401(k) on December 31 must be $0.
• There must be a triggering event:
  • Separation from service;
  • Attainment of age 59 ½ (a participant can withdraw earlier but may be subject to an additional 10% early withdrawal penalty);
  • Total and permanent disability; or
  • Death

Consider the Following Scenario

Marcy wants to use $200,000 of employer stock to purchase an RV and travel the USA.

Facts about Marcy:

• Filing status: Single.
• 35% marginal tax bracket.
• 62 years old.
• $400,000 of employer stock in 401(k).
• $60,000 cost basis on employer stock.
• Retired this year.

Option 1: Roll over all assets to an IRA and withdraw money to purchase an RV

Since Marcy is in the 35% tax bracket, she will need to liquidate $307,692 of employer stock from the IRA to cover the cost of the RV and travel. 

• $307,692 * 35% = $107,692.
• $307,692 – $107,692 = $200,000.
• Total tax without utilizing the NUA strategy = $107,692.
• Balance of employer stock remaining = $92,308.

Option 2: Utilize NUA

Marcy transfers all the employer stock, in-kind, to a taxable account and rolls the remainder of her 401(k) to an IRA. She will pay ordinary income tax on her cost basis in the stock at the time of transfer and will need to withdraw $235,294 from the taxable account to cover the cost of the RV and travel.

• $60,000 * 35% = $21,000.
• $235,294 *15% = $35,294.
• $235,294 – $35,294 = $200,000
• Total tax using NUA strategy = $56,294.
• Balance of employer stock remaining = $164,706.

Using the NUA strategy saved Marcy $51,398 in taxes and allowed her to keep more of her employer stock invested.

Summary

• If you own employer stock in a 401(k) or an employee stock ownership plan (ESOP) and you’re at least age 59 ½ or separated from your employer, the net unrealized appreciation (NUA) strategy may save you money.
• The NUA strategy works well for clients with low-basis employer stock in a retirement account who want to take a lump-sum distribution and are willing to pay some tax now.

For more information on how you can take advantage of the NUA tax strategy, contact the Financial Planning Team at 866.605.1901.

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