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There are a few niche financial planning strategies that are, as an advisor, really satisfying to implement with clients. Strategies that can make a huge impact on clients’ tax bills (for the better) and can show a quantifiable value that advisors bring to the table in the realm of financial advice. One of these strategies, for me, is Net Unrealized Appreciation (NUA).
The NUA strategy involves employer stock inside of said employer’s 401(k), profit-sharing, or ESOP plan that has appreciated in value(ideally, significantly). Already, you can see how this is, in fact, a niche strategy, as not everyone saving for retirement:
1. Works for a publicly traded company (NUA doesn’t work with private companies)
2. Owns stock that has increased significantly in value
3. Even has a 401(k) – (It must be a 401(k) – not a403(b), 457, pension, or any other employer-sponsored plan.)
However, if the stars align, NUA provides a one-time opportunity for big tax savings when executed correctly. It’s also worth noting that since NUA has immediate tax consequences while the alternative defers taxes by rolling over your employer stock to an IRA or simply leaving it in the plan, it’s more of a trade-off than a no-brainer. As such, each person’s unique circumstances must be analyzed before pulling the trigger. This post will cover the NUAnces (see what I did there?) of NUA and how to take advantage of one of my favorite IRS-blessed transactions.
There are three important figures to understand when discussing NUA:
1. Cost Basis
2. NUA itself
3. Market Value
Over the years of working with your employer, a portion of each paycheck is invested into investments of your choice. The price you pay for these investments is your cost basis. Again, this strategy only applies to your employer’s stock, and not any other mutual funds, ETFs, or other company’s stock that can be bought in your 401(k). So, if you never elected to invest a portion of each paycheck into your employer’s stock, then there is no NUA to begin with.
NUA specifically refers to the capital gain or “growth” of the employer stock.
Example: If, over the years, your total cost basis on your employer stock is, say, $10,000 and the stock is currently worth $50,000,then the NUA is $40,000 ($50k – $10K). If your employer stock has depreciated, or gone down in value - you guessed it - you do not have NUA.
Market value is simply the current value of all the shares you have purchased. This will fluctuate day to day as the stock price inevitably goes up and down (hopefully more up than down).
Now that we have the basics covered, let’s dive into the strategy itself using the numbers from above. Note that this is a very simplified example, and we will get into more real-life details in a bit:
- Cost Basis: $10,000
- NUA: $40,000
- Market Value: $50,000
Normally, when taking a withdrawal from a retirement account such as a 401(k), the gross withdrawal amount is subject to federal and state income taxes. So, a $50,000 withdrawal would add $50,000 to your gross income for the year and be taxed at the marginal tax rate of the bracket it lands you in.
The NUA Strategy provides an alternate route to accessing this $50,000 and paying a lower tax rate with one additional step. By transferring your employer stock in-kind to a brokerage account (non-retirement, individual or joint investment account), only the cost basis is taxed at your marginal income tax rate. Once the stock is in the brokerage account, it can be sold in part or in full to access the cash, or it can be held. Let’s first assume that it’s sold immediately. The $40,000 of NUA is taxed at long-term capital gains rates, which can be 0%, 15%, or 20%, depending on your total adjusted gross income for the year. Either way, long-term capital gains rates are more favorable (lower) than your income tax rate, which is where the tax savings comes in.
To quantify the tax savings, let’s say you and your spouse are in the 32% income tax bracket based on your adjusted gross income (remember, this includes the $10,000 of cost basis when distributed from the 401(k), and the $40,000 of NUA when the stock is sold) in 2024. This would also mean your long-term capital gains tax rate is 15%. For simplicity, let’s also assume you are over age 59 ½ (meaning no 10% early withdrawal penalty from retirement accounts) and live in a state with no income tax.
Scenario 1: $50,000 is withdrawn directly from the401(K):
- $50,000 x 32% = $16,000 in federal income tax
Scenario 2: Employer stock is moved to the brokerage account and then sold immediately.
- $10,000 x 32% = $3,200 in federal income tax
- $40,000 x 15% = $6,000 in long-term capital gains tax
- Total tax: $9,200
Tax Savings: $6,800
As you can see, NUA provides an opportunity for significant tax savings. However, in this oversimplified example, a few important details were left out to get the point across. Let’s look at some of the requirements to be eligible for NUA.
To be eligible to take advantage of NUA, one must meet 3requirements according to Internal Revenue Code Section 402(e)(4) .
1. 401(k)/Profit-sharing/ESOP must be distributed in a lump sum transaction
In the previous example, we assumed the 401(k) plan consisted only of employer stock. However, that is rarely the case in practice. More commonly, employer stock makes up only a portion of the 401(k) balance. The rest of the balance may be invested in various mutual funds. Since you must distribute the full balance in a lump sum (which in this context, can actually be multiple transactions as long as they are in the same calendar year), the rest of the account balance is typically rolled over to an IRA simultaneously to avoid any additional tax implications.
2. After a qualifying event
To have stock that has appreciated in value inside your 401(k)is not enough to be eligible according to the IRS. You must also have experienceda qualifying event, defined as one of the following:
- Age 59 ½
- Termination of service from the employer
- Disability
- Death
Furthermore, once at least one of the above qualifying events has occurred, the NUA transaction must be the first transaction (and thus a lump sum distribution) after the event has occurred. If a partial withdrawal is taken, then the account is no longer NUA-eligible until the next triggering event.
For example, if John leaves his job at age 57, and has $200,000of stock in his 401(k) with a cost basis of $60,000, he has an opportunity to utilize NUA. But John needs money from his 401(k) to pay for living expenses while he searches for his next job as he isn’t quite retired yet (and didn’t plan properly with an emergency savings account!). By taking a small partial withdrawal and not a lump sum, John disqualifies his account from using NUA until the next qualifying event occurs. Once John turns 59 ½, he will, again, be able to utilize NUA – only if he does a lump sum distribution as the first transaction thereafter.
3. Must be distributed in-kind
This should be known via the previous examples, but it bears repeating. The employer stock must be transferred in-kind (i.e. not liquidated first) to a brokerage account. If it is liquidated inside the employer plan first, the NUA opportunity is lost forever.
Just because you may be eligible for NUA does not mean the NUA strategy makes sense in all situations.
First and foremost, an NUA transaction has immediate tax implications – the cost basis is taxed as income during the year it is distributed. Some situations where NUA may not make sense include the following:
· If your NUA-eligible stock is through a previous employer (qualifying event: termination from service), but you are still working elsewhere, this could still have a significant income tax bill, especially in higher income tax brackets. Often times NUA transactions are done in retirement, when one’s income (and thus, tax bracket), has dropped considerably.
· If you left your employer before the year in which you turned 55, the cost basis will not only be subject to income taxes, but a 10% early withdrawal penalty as well.
· If your company stock has a high cost basis(i.e. $100,000 cost basis, $120,000 market value), you’d still be paying a lot of income tax just to save a little on the NUA.
· If you have sufficient liquid savings in other after-tax accounts (like a savings account) to fund any large purchases, there may not be a reason to even consider NUA - yet.
In all these scenarios, it may make more sense to simply defer the taxes altogether by keeping it in the employer plan or rolling it over to an IRA or another employer plan. Consult a tax advisor or financial planner versed in NUA to help make the best decision based on your goals and objectives.
Since NUA requires an in-depth analysis of one’s unique financial situation to determine whether it makes sense, here are a few other considerations that may help arrive at that decision.
The IRS code requires that the employer plan be depleted in a lump sum transaction. However, this does not mean that all the stock needs tobe transferred to the brokerage account for NUA treatment.
Example:
Jane has a 401(k) with a balance of $1mm, of which $100K is company stock with a $20K cost basis. If Jane and her financial planner determine that she should take a $50,000 distribution to pay off debt prior to retirement, she can elect to take just half of her stock ($100,000 / 2) and transfer it to a brokerage account for NUA treatment, and rollover the rest of the 401(k) balance (including the other $50K of stock) to an IRA. By doing so, Jane only pays income tax on $10,000 of cost basis rather than $20,000, and long-term capital gains tax on $40,000 of NUA, rather than $80,000 if she moved it all to the brokerage account.
Generally, stock held in a brokerage account gets a step-up in basis when the original account owner dies, and the beneficiary inherits the stock. If a stock was originally purchased in a brokerage account for $50,000,and it is worth $250,000 at the time of the account owner’s death, then the beneficiary’s cost basis “steps up” to $250,000, which allows them to immediately sell the stock if needed, with no capital gains tax at all. Unfortunately, stock that originated in an employer plan and received NUA treatment is not eligible for a step up in this scenario.
While stock that was used in an NUA transaction is not eligible for step up in basis, the good news is, under Treasury Regulation 1.411-8(b)(4)(ii),the capital gains from selling the stock are not subject to the 3.8% Medicare surtax that applies to nearly all other forms of taxable income over $200,000if single, $250,000 if married filing jointly.
After stock is transferred to a brokerage account as part of an NUA transaction, the capital gains are treated as long term when sold, regardless of the actual holding period. However, if the stock is not sold and continues to appreciate, any subsequent gains are taxed at long or shorter-term gains depending on the holding period beginning when the stock was deposited to the brokerage account.
Example:
Chris retires in October and shortly after, utilizes NUA on his company stock with a cost basis of $40,000 and a market value of $350,000.He plans to sell the stock in January when he will be in lower income tax year. Over the next few months, the stock appreciates further to a market value of $400,000.If Chris sells all the stock, he will pay long-term capital gains tax (0%, 15%,or 20%) on the original $310,000 of NUA, and short-term capital gains tax(same rate as income tax bracket) since the stock was sold less than a year after the new holding period started, when the stock was deposited to the brokerage account.
I don’t think there is an official term for this, but I feel the easiest way to understand it is by calling it a 2nd cost basis(i.e. the 2nd cost basis is $350,000 – the value of the stock when it moved to the brokerage account and the new holding period started).
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At the end of the day, NUA can provide significant tax advantages if the circumstances call for it. But, as the saying goes “Don’t let the tax tail wag the dog” – i.e. don’t make your NUA decision based on taxes alone. With the help of a professional, look at your full financial picture and determine whether you actually need the money you’d get from an NUA transaction, or if it can be pulled from an even more tax-friendly source.
Visit www.sparkwealthadvisors.com/contact if you’d like to schedule a no-cost consultation regarding NUA or other financial goals.
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