If you have a large amount of highly appreciated employer stock in your 401k than this article is for you. We will cover the basics of a tax strategy called Net Unrealized Appreciation (NUA). It’s important to understand that this strategy is not a one size fits all approach and needs to be looked at individually to see if it would be beneficial to you.
Here’s a very basic example so you can understand the strategy;
You have been working at a company for many years and have accumulated a lot of your employer’s stock. The company has had tremendous growth while you have worked there and the stock steadily increases every year. After a quick estimate you think there has been around $200,000 in company stock contributions but the value of the stock is worth $700,000.
A $500,000 gain! But how is that money going to be taxed when you withdraw it?
Scenario #1 – You retire and roll over your entire 401k to an IRA. Each year you withdraw money from your IRA it will be taxed at your ordinary income tax rate.
Scenario #2 – You retire and elect using the NUA strategy. This will allow you to take the $500,000 and have it taxed as capital gains and the $200,000 will be taxed at your ordinary income tax rate. This can save a significant amount of taxes.
As I mentioned this example is very basic so it’s important to talk to a financial or tax professional before making your decision. Let’s dive a little deeper into the criteria and execution portion.
4 things you need to be aware of;
The employer stock is required to be “transferred in-kind”. It should not be sold in your 401k and then transferred afterward.
The NUA strategy must be completed all at once which is also known as a “lump-sum distribution” – The participant has the option on where to distribute the money and it can be split up between an IRA rollover and NUA election to further defer taxes on a portion of the account.
The entire account needs to be distributed in a “single tax year”. This doesn’t necessarily mean at the exact same time, but a tax or financial professional can walk you through it.
The lump-sum distribution can only happen after one of four qualifying events or “Trigger event”; Reaching age 59 ½ (most common), Death, Disability, Separation from service.
4 scenarios that increase the benefits of NUA;
Tax rates - The larger the difference between your ordinary income tax rate and your long-term capital gains tax rate, the greater the potential tax savings from electing NUA tax treatment of company stock.
High Amount of Appreciation - The larger the dollar value of the stock's appreciation, the more the NUA rules can save you on taxes.
% of NUA in account - A NUA that is a higher percentage of total market value creates a greater potential tax savings. It can enable more of the proceeds to be taxed at the lower capital gains rate and less will be taxed at income tax rates.
Time horizon to distribution - The longer you plan to keep your assets invested in an IRA, the greater the potential benefit of that account's tax-deferred growth.
A shorter time frame makes the NUA election more attractive
A longer time frame makes the NUA election less attractive.
It’s important to remember that this is strategy can be complex but it is worth the investment of your time if you can save significant amount of money on taxes. Once again, always discuss this strategy with your financial professional before attempting to execute it.
Hope you found this article helpful and good luck out there!
All investing involves risk, including the possible loss of principal. There is no assurance that any investment strategy will be successful.
Before deciding whether to retain in a 401(k) or roll over to an IRA, an investor should consider various factors including, but not limited to, investment options, fees and expenses, services, withdrawal penalties, protection from creditors and legal judgments, required minimum distributions and possession of employer stock. Please view the Investor Alerts section of FINRA website for additional information.