A Favorable Tax Planning Tool
Net unrealized appreciation (NUA) is a favorable tax planning opportunity that can often save a taxpayer tens of thousands of dollars. However, this tax planning opportunity is often underused because most people are unaware of its existence. In order to utilize this tax planning opportunity, an employee must own company stock in his or her 401(k) account. Other company-sponsored retirement plans may also apply when discussing NUA, but the primary type of account is the 401(k) so this is what we will address here.
For many employees that participate in a company-sponsored 401(k) plan, when they retire or terminate employment with the company, they would choose to “rollover” the entire balance of their 401(k) account into a self-managed IRA. However, when the employee owns company stock in their 401(k), they should analyze whether this is the best thing to do. Net unrealized appreciation (NUA) is simply the difference between the cost basis (what you paid for the stock) and the current fair market value of the employer stock in your 401(k) account. The IRS allows for this net unrealized appreciation to be treated as a capital gain, which is taxed at lower tax rates than ordinary income tax rates. The larger the appreciation of the employer stock in your 401(k) account, the bigger the opportunity to save more in taxes by utilizing this strategy. For example, if you retire with $750,000 of employer stock in your 401(k) account and this stock only has a cost basis of $150,000, you would have net unrealized appreciation of $600,000 in this stock.
In the example above, if you choose to employ the NUA strategy and take the $750,000 of company stock out of your 401(k) account “in-kind”, you would currently only pay income taxes on the $150,000 cost basis. To be treated as an “in-kind” distribution, you would need to take the shares out of the 401(k) as shares of your company stock – not converted to cash. The other $600,000 of appreciation would remain untaxed until you actually sell the stock. When you sell the stock, this $600,000 of NUA would receive long-term capital gain tax treatment. Any further appreciation of this stock after the date of the distribution would receive either short-term capital gain (less than 12 months) or long-term capital gain (12 months or longer) treatment depending on the length of time that has passed since the date of the distribution.
If you choose to utilize the NUA strategy, you would take the employer stock out of your 401(k) account and direct this stock into a taxable (non-IRA) brokerage account. When this occurs, the ordinary income amount that you would have to report on your tax return would ONLY be the cost basis of the employer stock. The remainder of your 401(k) account (everything other than the employer stock) would be rolled over into a traditional IRA Rollover account.
In order to qualify to use this net unrealized appreciation strategy, you must meet the following strict criteria:
- You must distribute your entire account balance from all employer plans within one year.
- You must take the distribution of employer stock as shares – not cash.
- You must have completed one of the following:
- Be age 59-1/2
- Separated from service and be at least 55 years old (or a 10% penalty may apply)
- Become totally disabled
How DHJJ Can Help
If you have a considerable amount of employer stock in a company-sponsored retirement plan and would like to have someone analyze whether the net unrealized appreciation (NUA) strategy would be appropriate for you, please contact your DHJJ Financial Advisor at (630) 420-1360 or fill out the form below for more assistance.