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 In addition, if you are under age 59½ there is a 10% early withdrawal penalty applied on the amount withdrawn when any distributions are taken.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.
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.