If you have company stock in your 401(k), you may want to consider whether to take advantage of net unrealized appreciation at retirement. Under the net unrealized appreciation rules, employees can roll over the portion of their 401(k) invested in company stock to a brokerage account and pay tax at more favorable long-term capital gains tax rates (rather than ordinary income) when the shares are sold. It doesn’t always make sense to use NUA – or keep employer stock in your retirement plan – so carefully weigh the pros and cons.
Net unrealized appreciation rules
If you currently have company stock in your 401(k), consider whether to use the NUA tax strategy or potentially diversify your holdings. When you leave the company, you have the option to roll your 401(k) over to an IRA. If you are retiring and have employer stock in your 401(k), under the NUA rules, you can consider rolling only the stock into a brokerage account. The rest can go into an IRA.
You’ll pay ordinary income tax on your cost basis in the employer stock. The remaining spread will be eligible for long-term capital gains tax treatment when the shares are eventually sold.
The difference between the original cost of the stock and the current market value of the shares at the time of distribution is the net unrealized appreciation.
Net unrealized appreciation example:
Jordan is 62 years old, married, and a longtime employee of Company C. His 401(k) is worth $2M, $500,000 of which is invested in Company C stock. Having appreciated significantly over the years, Jordan’s cost basis in the employer shares is only $150,000.
He retires and takes an in-kind distribution of $500,000 (company stock) into his brokerage account and a direct rollover of $1.5M to his IRA. He pays ordinary income tax on $150,000 (his cost basis, which is the amount he paid for the stock over the years). The direct rollover to an IRA has no tax consequences. Assuming no other income for the year, this puts Jordan in the 22% federal tax bracket for ordinary income in 2021.
Here’s where the potential benefits of net unrealized appreciation come in:
- If Jordan subsequently sold all the company stock, he’d pay long-term capital gains tax on $350,000 at 15%, plus the 3.8% Medicare surtax, for a total tax rate of 18.8%.
- If Jordan rolls the whole $2M into an IRA instead, and takes a $500,000 distribution, he’ll pay income tax on the full withdrawal. The remaining $1.5M will continue to grow tax-deferred. This would push him into the 35% tax bracket federally, 38.8% including the Medicare surtax.
In either situation, if Jordan lives in a state with an income or capital gains tax, there would be additional tax implications.
The above NUA example assumes Jordan sells all his Company C stock the same year. But he doesn’t have to. He won’t recognize a long-term capital gain until he sells the shares, though dividends will be taxable annually.
- Entire vested balances from all retirement plans with the company must be distributed within one calendar year.
- The company stock must be distributed in-kind. This means the actual shares will transfer to a brokerage account, not cash.
- The transfer must happen after you leave the company, reach age 59 1/2, or following your death/disability. Note, however, if you separate from service before age 59 1/2, you’ll owe a 10% penalty for early withdrawals on the taxable distribution.
Benefits of using net unrealized appreciation
NUA isn’t right for everyone. But in certain situations, the net unrealized appreciation rules can offer additional planning opportunities. Here are some potential benefits of NUA.
- Avoid paying income tax on your entire 401(k) balance. The primary benefit of NUA is the ability to pay tax at more favorable long-term capital gains tax rates instead of regular income, like other pre-tax savings vehicles.
- Reduce your assets subject to required minimum distributions (RMDs) at age 72. This can improve tax planning opportunities in retirement.
- Flexibility to sell employer stock on your own terms. Since there are no holding period requirements, you are free to sell the stock whenever you please. In 2021, married couples pay 0% tax up to $80,800 in long-term capital gains, assuming no other income.
- Accomplish charitable goals. If you have charitable goals, an option could be to donate the stock using a donor-advised fund. After paying income tax on the basis, you could receive a tax deduction for the entire market value of stock donated if you itemize deductions. However, since you have to pay tax when you do the NUA rollover, other highly appreciated long-term shares in your portfolio might be better candidates for donations of stock.
What are the downsides of NUA?
There are many situations when it doesn’t make sense to use the net unrealized appreciation strategy or hold employer stock in your 401(k).
- Concentration risk. Many employees hold way too much employer stock already. Between stock options, restricted stock units, employee stock purchase plans, and other types of equity compensation, voluntarily adding to the position in a retirement plan doesn’t always make sense. Diversifying company stock has tax implications, except if you sell the stock in a 401(k). So if you are already overweight employer stock, using NUA could actually hurt you financially. Compounding the issue, at the beginning of retirement, you’re the most vulnerable financially.
- Tax savings don’t materialize. If your tax bracket when you elect NUA is higher than what it will be in retirement, you could end up paying more in tax. Also consider the loss of further tax-deferred growth as the money is in a taxable account, not an IRA. With any financial decision, taxes should be a factor, but don’t let the tax tail wag the dog. After all: tax laws change, sometimes dramatically. Current proposals would nearly double the highest long-term capital gains tax rate, eliminating the central benefit of this strategy for affected taxpayers. If it passes, of course.
- Trigger other changes to your tax situation. Depending on your taxable basis in the stock, recognizing a large amount of income could trigger the 3.8% Medicare tax. The tax applies to income and capital gains. Taxpayers’ AGI and MAGI also determines Medicare Part B and D premiums and other tax deductions/credits.
- No step-up in basis on NUA portion at death. Under current law, when most taxable assets are inherited, they receive a step-up in basis to the fair market value on the date of death. This means your heirs could sell the stock immediately (in theory) and pay no tax at all. However, when NUA is inherited, it does not receive a step-up in basis. Instead, the net unrealized appreciation (difference between the original cost basis and the market value when the shares were distributed) is treated as income in respect of a decedent (IRD) and taxed to beneficiaries as ordinary income. Any subsequent gain after distribution is eligible for a step-up in basis under current law.
You’ll also need cash to pay the tax on the NUA rollover. You could raise cash by selling stock or taking money from an IRA, but those moves will have additional tax consequences. And you also need to factor in regular living expenses in retirement.
Should you say no to NUA?
It depends! Discuss with your financial and tax advisor before making a decision and consider your other options. For example, sometimes you can make after-tax contributions to a 401(k) to ‘buy down’ the basis in company stock. This shrinks the component taxable as income from the rollover of company stock. Of course, it also increases the taxable spread where long-term capital gains tax applies.
Depending on your ultimate goal with the NUA strategy, another option might be annual Roth conversions in retirement. This reduces assets subject to RMDs and provides flexibility to convert just enough to avoid triggering negative tax consequences. If you are charitably inclined, qualified charitable distributions (QCDs) from your IRA may be an option, rather than donating company stock using a donor-advised fund. The good news is that there’s often more than one way to accomplish a financial goal.
This article was written by Darrow Wealth advisor Kristin McKenna, CFP® and first appeared on Forbes.