Employer-sponsored retirement plans like 401(k)s offer a lot of savings, investment, and tax advantages, but you have to be paying attention to make the most of them. Some of the best tax strategies with retirement savings can be complex and require a good bit of planning, without which the strategy and benefits could be lost forever.
In some cases, poor planning not only results in lost strategies but could also create additional taxes or penalty fees. Since most people dislike being taxed the one time, we tend to get really annoyed when we’re taxed twice – especially when we don’t have to be. One such strategy that offers a tremendous upside (but also has a lot of nuance) is called a Net Unrealized Appreciation tax strategy. Properly taking advantage of a NUA strategy could save you tens of thousands or more in taxes. Let’s dive into what NUA is really about and how to best take advantage of the strategy when it comes to your retirement savings.
What is Net Unrealized Appreciation?
Simply put, NUA is the growth (appreciation) over the basis (what you paid) for your investment. Take what you paid for the stock and subtract that from the current price, this leaves you with you NUA. For 401(k)s, it is typically the cost basis of all the shares and the current market value. While NUA exists for most investments with gain, there is really only one area that receives special attention with 401(k)s and other retirement accounts: company stock. Internal Revenue Code Section 402(e)(4) provides the rules for how you can receive special tax treatment of company stock held in an employer-sponsored retirement plan under the NUA rules. Ultimately, the goal is to take your gain inside of the tax-deferred retirement plan, distribute it, and have it taxed at long-term capital rates instead of ordinary income rates. Why does this matter? Long-term capital rates are typically significantly lower than ordinary income rates, meaning you pay less in taxes. NUA is also just subject to the standard capital gains rate schedule (0%, 15%, and 20%) and is not subject to the additional federal Medicare surcharge of 3.8 percent that can be charged on net investment income.
NUA in Action
Let’s look at an example of why this is so powerful. Jane works for XYZ Company that offers a 401(k) profit sharing plan. Over the years, she contributes $150,000 to the plan in which she buys company stock. XYZ Company has grown significantly over the years and the stock has performed well, raising the value to $650,000. Under normal distribution rules, the entire $650,000 would be taxable as ordinary income whenever Jane takes a distribution, either in part or in whole. Most likely, she would take distributions over time and each would be taxed as ordinary income. Instead of taxing the entire amount as ordinary income, the government allows Jane to take the money out of the plan and have the NUA taxed at long-term capital gains rates instead of ordinary income rates. In this case, the NUA would be $500,000 (market value of $650,000 minus her basis of $150,000). The basis will still be taxed at the ordinary income tax rate in the year of distribution and could be subjected to the 10 percent early withdrawal 72(t) penalty tax if the withdrawal occurs before age 59.5. But the NUA portion, $500,000, would be taxed at long-term capital gains rates whenever the stock is sold. In the case of Jane, if her ordinary income rate is assumed to be an effective rate of 24 percent and her long-term capital gains rate is 15 percent, she would pay a total of $156,000 of taxes on the $650,000 account at ordinary income rates, and only $111,000 (.24 x $150,000 plus .15 x $500,000) with a NUA strategy. That’s a tax savings of $45,000 – a pretty significant savings that comes to nearly 10 percent of her retirement portfolio. While this example simplifies the tax situation a lot, it does demonstrate how significant tax savings are possible under the strategy.
Proceed with Caution
The IRS and applicable code section lay out very specific requirements to follow in such cases, so you have to be very careful. First, the company stock needs to be distributed to the participant “in-kind.” And they mean it. That means the actual company stock needs to be distributed out of the plan to the individual. You cannot transfer out cash from the plan. This means you need to have the stock transferred out of the retirement account and into a taxable investment account. Any other funds in the retirement plan would need to be distributed from the plan also and likely rolled over into an IRA or another qualified retirement plan. If you roll the entire amount of your 401(k), including the company stock, to another retirement plan or IRA, you will no longer be able to take advantage of the NUA strategy. The distribution must also meet the definition of a “lump sum distribution,” meaning the entire account balance must be distributed to the individual within a single year. The plan must have a balance of zero dollars by December 31, assuming the plan follows calendar years, of the year in which the distribution is made. The “lump sum distribution” also needs to be the result of a triggering event, including
- attainment of age 59.5,
- separation from service, or
While in-service distributions can qualify for the special NUA treatment, you need to be careful. First, you need to be over age 59.5 or be disabled within the meaning of Code Section 72(m)(7), which defines disability as the inability to engage in “any substantial gainful activity.” Meeting this definition can be challenging. Additionally, in-service distributions can be a challenge if money is contributed late in the calendar year, resulting in a small balance on December 31, and thereby eliminating the ability to get the special NUA tax treatment. Another issue to consider with NUA planning is how a distribution can potentially increase your current taxable income and effective tax rate. This needs to be accounted for as it could cause you to be bumped into a new tax rate. Additionally, when you move the employer stock out of the retirement plan, you can no longer roll it to an IRA or other tax-advantaged retirement plan. In such a case, you would lose the tax benefits that go along with retirement plans and some of the creditor protections.
In other words, a NUA isn’t the best choice for every scenario. Sometimes, it might be best to just roll the money to an IRA or leave it in the 401(k) and not do a NUA strategy with employer stock. Understanding the complexities that exist around NUA can be challenging, and planning cannot be done in a vacuum. Any distribution from a qualified plan or NUA strategy needs to be incorporated into an overall plan that looks at your long-term retirement goals, investment strategy and tax implications. Putting all of this together will typically require a well-qualified team that has financial planning, retirement and tax expertise. But, in the end, if you have highly appreciated employer stock in your retirement plan and you miss out on this strategy, you could end up costing yourself thousands of dollars in extra taxes.