By: Joseph Goldy, AAMS®
With over $5 trillion in 401(k) plans across the United States as of 2019, this qualified retirement plan's continued popularity is without question. Although the amount of 401(k) money invested in company stock has declined in recent years, according to the Investment Company Institute, investors still have about 6% of plan assets concentrated in their employer's stock.
Net Unrealized Appreciation (NUA) in a Previous Employer’s Retirement Plan
Those holding highly appreciated company stock in their previous employer's retirement plan, electing for net unrealized appreciation (NUA) treatment of the shares, could present an opportunity.
How to Save Taxes on your Net Unrealized Appreciation (NUA)
It allows someone to pay long-term capital gain tax rates on the appreciated portion from a tax planning perspective rather than higher ordinary income rates.
To benefit from NUA treatment, one must make the election on the previous employer's distribution paperwork. They must also agree to receive the stock in shares that are transferred in kind to a taxable brokerage account as opposed to selling the stock and moving the proceeds into their IRA.
When this transfer of company shares occurs, a portion of the value will be the cost basis. This cost basis portion comes from the average fair market value of the shares as the employee purchased them over the years and tracked by the plan administrator while the employee was working at the company.
Further, this amount is taxed as ordinary income in the year of the NUA election. The remaining value of the transferred shares above and beyond this cost basis portion represents the NUA amount and benefits from lower long-term capital gain treatment when the person eventually decides to sell the shares in the future.
The share's transfer date leaving the old 401(k) and moving into a taxable brokerage account is when the clock begins to determine the short or long-term capital gain treatment for the portion above the NUA amount. If the shares' value falls below the NUA value from the time of distribution, it simply reduces the NUA amount.
Contrast this with the investor selling the company stock and rolling over the proceeds into an IRA. Not only will the money eventually distributed from the IRA be taxed as ordinary income, but the investor is required to begin recognizing that income with required minimum withdrawals starting at age 72 regardless of whether the money is needed or not.
Example of this Net Unrealized Appreciation Tax Strategy
Sam just retired and has a 401(k) valued at $1.5 million and is considering rolling over the entire balance into an IRA with his financial planner. Of the $1.5 million, $500,000 is from 10,000 shares of company stock, while the remaining $1 million is diversified in mutual funds. The $1 million of mutual funds can be sold and distributed as a lump sum rollover into an IRA with no tax consequences. Although Sam's remaining $500,000 of employer stock can also be sold and rolled over, he decides instead to make an NUA election and transfer the shares in kind into a taxable brokerage account.
During Sam's working years at the company, his 401(k) plan administrator had been tracking the average fair market value of the company shares he has purchased, and for our example, we'll say this comes to $200,000 or $20 per share. This now becomes Sam's cost basis in the shares when he transfers the $500,000 company stock to his taxable brokerage account. Recall too, that this amount will be taxed as ordinary income in the year of the transfer. The remaining $300,000 ($30 per share) becomes his NUA amount, which always receives the long-term capital gain tax rate.
Shortly after doing the NUA transfer, Sam decides to sell 2000 shares of stock that is now trading at $60 for $120,000. $40,000 ($20 per share) is his cost basis portion and will not be taxed since it was previously taxed upon the transfer as ordinary income. The next $60,000 or $30 per share is the NUA portion and is taxed as a long-term capital gain. The final $20,000 or $10 per share of appreciation above the NUA amount will be taxed at the short-term capital gain rate since Sam sold these shares less than a year of the transfer taking place.
A year later, Sam sells another 2000 shares with the stock now valued at $70 per share for $140,000. Of the stock's $70 sale price, $20 is allocated to his cost basis and not taxed. $30 is the NUA portion, which is taxed at long-term capital gain rates, and the final $20 of appreciation is also taxed at long-term capital gain rates since it has now been longer than a year and a day since the original transfer took place.
Finally, Sam sells another 2000 shares, but now the stock has declined below its original $50 per share at the transfer time and is trading at $40. After backing out the $20 per share cost basis, which he is not taxed on, the remaining $20 per share of value is all NUA and will receive long-term capital gain tax treatment.
Rather than doing a rollover of the company stock, the example with Sam underscores the purpose of making the NUA election twofold. Had Sam sold the shares and rolled the proceeds into his IRA, he would eventually have had to pay higher ordinary income rates upon any IRA withdrawals in the future. Secondly, Sam has more control over when he recognizes the future income since the shares are held in a taxable brokerage account that is not subject to required distributions as an IRA would be. Whether or not it is right for you will be based on your current and expected tax brackets and your financial goals.
Author’s Bio
Joseph Goldy, CFP®, is a wealth advisor and CERTIFIED FINANCIAL PLANNER™ at Highland Financial Advisors, LLC, a fee-only fiduciary wealth advisory firm based in Wayne, New Jersey.
Joe specializes in working with newly independent women because of divorce or losing a spouse. He understands firsthand the value of having a clear financial picture pre- and post-divorce and a plan to restate goals as a single person. When he is not helping clients, Joe enjoys spending time with his two sons outdoors and volunteering to help raise money for Type 1 diabetes organizations.