One of my clients is retiring this year and we were discussing what to do with his 401(k) at our bi-annual meeting. While typically most people either opt to leave their 401(k) as-is in their company plan or roll it over to an IRA, a third option is available if you own your company’s stock in the plan. Due to the amount of stock my client has, I assumed that he had heard of the tax strategy “Net Unrealized Appreciation –(NUA)”. To my surprise he had not so I thought I’d shed some light on the subject in case others find themselves in the same predicament.
Net unrealized appreciation on company stock allows you to take stock from your qualified retirement plan and pay ordinary income tax on the original cost of the stock rather than the current market value at the time of the withdrawal. The difference between the value of the company stock at the time it was purchased to the time of the distribution is called net unrealized appreciation or NUA. If you withdraw all of your funds from the plan, then you can defer the tax on the NUA until it is actually sold, at which time you will pay only long term capital gains (not ordinary income) tax on the appreciation.
While continued risk of owning a concentrated stock position should be considered, this strategy can be significantly beneficial if the company stock has appreciated considerably since the time you acquired it. The added advantage would be the difference between your ordinary income tax rate and the capital gains rate on the NUA that exists when you sell the stock.
A few things to note on how this works:
- You must take the distribution as a lump sum for the full balance of the retirement plan and you must take this distribution within one calendar year. Partial distributions do not receive the NUA tax benefit, nor does taking any money out of the plan after retirement but before the lump sum distribution.
- The distribution can be split between a rollover into an IRA and the outright distribution of the company stock.
- You may take out all or a portion of the company stock, transferring any balance to the IRA.
- Assets rolled into the IRA (including any company stock not distributed outright) are not taxed at the time of the transfer. Assets from the IRA are taxed as ordinary income when they are withdrawn.
- You pay ordinary income taxes on the cost basis of the stock for the year of the distribution. You defer taxes on the NUA.
There are pros and cons to doing a NUA and they are certainly not for everyone. A NUA/lump sum distribution may only take place after a qualifying event (separation from service, death, disability). If you have taken any other distribution (RMD, in-service withdrawal, etc.) after the triggering event, you are no longer eligible for the NUA treatment.
When deciding whether or not to take advantage of the NUA strategy, get formal documentation of the cost basis of the stock before initiating any transfer. Not all benefits personnel know about the NUA so find someone who does at your employer. You’ll also want to do a detailed analysis of the tax comparison of the NUA vs. a traditional rollover. As this a complex strategy and is impactful on your long-term financial plan and retirement, utilizing your financial advisor and tax professional in this instance is strongly recommended.
The information contained in this post is not intended as investment, tax or legal advice. StrategicPoint Investment Advisors assumes no responsibility for any action or inaction resulting from the contents herein. Megan’s opinions and comments expressed on this site are her own and may not accurately reflect those of the firm. Third party content does not reflect the view of the firm and is not reviewed for completeness or accuracy. It is provided for ease of reference.