Using NUA to Cut Taxes on your 401(k)

Calculator and investment statementIn this previous post, I explained 3 reasons why you might not want to rollover your retirement plan to an IRA. One of those reasons, Net Unrealized Appreciation or NUA, warrants further explanation.

If you have highly appreciated stock in your 401(k) at work, NUA is a little known tax strategy that may allow you to significantly reduce your tax liability on those shares.

Normally, distributions from 401(k) plans are taxed as ordinary income at your tax bracket. For example, if you are in the 25% tax bracket, your Federal Income tax may be up to 25% of your distribution. A $100,000 taxable distribution could have a federal tax bill of $25,000 or more depending on your tax bracket.

Under certain circumstances, the IRS allows individuals to take a distribution of company stock from their retirement plan and tax on that distribution at more favorable capital gains tax rates. Here is how it works:

Net Unrealized Appreciation is simply the difference between the cost basis on the company stock held in your 401(k) and the current share price. If a stock is trading at $100 and the cost basis is $10, the net unrealized appreciation is the difference or $90.

If done correctly, you would pay ordinary income tax on the basis of that stock – $10 per share, in this case. The net unrealized appreciation, $90 in this example, is taxed at capital gains tax rates rather than at ordinary income tax rates when it is when you sell your shares. Capital gains are taxed at 0%, 15% or 20%, far less than ordinary income tax rates.

Let’s review the math in our hypothetical situation —

$100,000 Value of 1,000 hypothetical shares company stock in your 401(k)
$ 10,000 Cost basis on that stock
$ 90,000 Capital Gain

If you distribute the entire 1,000 shares of company stock, you pay ordinary income tax on the cost basis of $10,000 during the tax year you made the distribution. Someday, when you sell those shares you will pay capital gains tax on the difference between the cost basis ($10 per share) and the value of the stock at the time you sell it.

Does that make sense?

Before you run out and exercise this strategy, there are some rules you must follow.

1. Always consult a qualified tax professional before exercising any NUA strategy. If you make a mistake, your entire distribution may be taxable at the highest possible tax rates.
2. While the NUA amount is taxed as capital gains, the cost basis is taxed as ordinary income just like any other retirement plan distribution. In the example above, you would pay ordinary income tax on $10 per share, capital gains tax on any amount over that.
3. If you are under age 59 ½ , the distribution may be subject to a 10% penalty.
4. The distribution must be a lump sum distribution.
5. The company stock must be distributed in-kind from your retirement plan.
6. Unlike other shares of stock, NUA shares do not receive a step-up in basis upon death. Your beneficiaries will pay capital gains tax when they sell the stock, just like you would have.
7. The entire distribution must be completed before December 31.

If you work for a large, successful, publicly traded company, and you own company stock inside your plan, you may be a candidate for this strategy.

NUA strategies can be complicated and mistakes can be expensive. Consult your tax advisor or contact me to discuss whether NUA may be appropriate for you.