by: Mariella Foley, CFP®, ADPA®, CDFA®

 

Employees of publicly traded companies often have the option of purchasing company stock in their 401(k) accounts.  Over the years, these scheduled stock purchases can result in accumulating a significant amount of company stock in a 401(k) account that could also include sizeable gains.  This appreciation is referred to as Net Unrealized Appreciation (NUA) and is defined as the difference between the original cost basis and current market value of a company stock held inside of an employee’s 401(k).

If you hold company stock in your 401(k), the following NUA tax strategy could be beneficial to utilize depending on your specific situation.

In this brief article, I will explain:

  • The benefits an NUA can have for you;
  • Tax strategy of an NUA and who is eligible; and
  • Factors to consider.

How Net Unrealized Appreciation could benefit you

Distributions from a 401(k) are taxed as ordinary income. In addition, if you are under age 59½ there is a 10% early withdrawal penalty applied on the amount withdrawn when any distributions are taken.  However, Section 402(e)(4) of the Internal Revenue Code provides an opportunity for an eligible employee to withdraw shares of their employer’s stock from their 401(k) in-kind.  By doing so the employee will pay the more favorable capital gains tax rate on the NUA (which is lower than ordinary income tax rates) upon selling the company stock if certain criteria are met. This could mean significant tax savings for the employee.

Or would it?  There are details to the strategy that are important to note.

How the NUA tax strategy works

To be eligible for the lower capital gains tax rate upon the subsequent sale of the shares, the income portion of the shares must be recognized immediately at ordinary income tax rates when the shares are distributed in-kind from the 401(k). The reportable income equals the amount of the original cost basis of the shares.  What makes this strategy effective but unique to each employee’s situation is that depending on the amount of income being recognized, it could create a cash flow issue at tax time if not managed properly. 

Who is Eligible?

This strategy can only be initiated following one of these triggering events: Death, Disability, Separation from service or Turning age 59½.  It cannot be initiated as an in-service distribution.

An example:

James is a 58-year-old employee and has accumulated $1.2M in his 401(k), which includes $600k in company stock. The company stock in his 401(k) has amassed $400k of appreciation (Net Unrealized Appreciation) with a cost basis of $200k.

Upon retiring, James decides to rollover his 401(k) to an IRA.  By rolling over the entire balance of the 401(k) it continues to grow tax-deferred until he begins to withdraw it no later than age 72.  At that time, it is taxed at ordinary income tax rates.

Alternatively, if James elected to take a lump sum distribution of the $600K in non-company stock assets as a direct rollover to his IRA, but take all his company stock ($600k) as an in-kind distribution, the company shares would be separately transferred to his brokerage account. With this strategy, the in-kind distribution of the stock would trigger a taxable event in the amount of the original cost basis of the company stock ($200k), while the $400k of capital appreciation would remain deferred until the stock is later sold and taxed at long-term capital gains rates.  

Under this alternate scenario, the direct rollover portion going to the IRA would not be immediately taxable and would not be subject to any early withdrawal penalty.  It would however be taxable as ordinary income when amounts were withdrawn.  Additionally, there would be no applicable tax penalty for the NUA portion (capital appreciation) of the in-kind company stock distribution.  When the shares of company stock were later sold, they would be taxed at the prevailing long-term capital gains rate, as opposed to being taxed at ordinary income tax rates when withdrawn from an IRA.

Factors to consider:

  • Marginal Tax Rate – Compare today’s marginal tax rate to what is expected in retirement. If you expect to be in a lower tax bracket in retirement, this strategy may not be beneficial since it would mean accelerating income while in a higher tax year. It is more advantageous to withdraw the funds in a lower tax rate year.
  • Tax Lots – Not all the shares of company stock need to be distributed in-kind. Closely review the cost basis of all the tax lots and if there is a significant disparity in cost basis among the lots, consider distributing only the lower cost shares. This will minimize the amount of income that would be taxable immediately.
  • Tax Year – The entire 401(k) account is required to be distributed in one single tax year. If utilizing this strategy, the company stock would transfer in-kind, and the balance would be rolled over to an IRA. While this is often a strategy that is coordinated as a transition to retirement, it should be discussed with your CPA to decide if it would be more beneficial to wait a year.
  • Future Income – Reducing the amount to be rolled over to an IRA means lower future required minimum distributions after age 72. This could be beneficial if you expect to be in a higher tax bracket in the future.
  • Liquidity for taxes due – If you elect this strategy, be sure to consult with your advisor or CPA to properly estimate how much you would owe in taxes from this distribution as well as the timing. Ensure that you will have sufficient liquidity for the incremental tax liability. If it is necessary to sell any investments to raise the necessary cash, consider if that would generate an additional tax liability.
  • Non-qualified assets – If your investment portfolio consists mostly of retirement assets and there is limited access to liquidity in your near-retirement years, this could be an opportunity to generate some additional liquid funds if you appropriately manage the corresponding tax liability. The distributed stock would be transferred to a brokerage account and can later be sold and diversified accordingly.
  • Company outlook – Is your outlook on the company stock still positive? If your objective is to retain a portion of your shares, this could be a tax-efficient way to transfer them to your investment portfolio. There are potential planning opportunities for the highly appreciated shares, including charity or factoring into your overall estate plan.

Conclusion

The Net Unrealized Appreciation tax strategy provides additional options for those who may benefit from receiving their appreciated company stock from their 401(k) in-kind. Company stock can be sold immediately afterwards to reduce concentration risk; however, it is not required that the stock be sold. The appreciated stock can even be gifted to charity or used as part of an overall estate plan. The key is to consider all the possible options, contributing factors and to look closely at each potential outcome to determine if the strategy makes sense for you.

If you are considering this strategy or simply want to learn more, contact a RTWM Wealth Advisor today. They can assist you in analyzing the various factors and deciding what option might be right for you.

 

 

Sign Up For the Round Table Newsletter