Company Stock in your 401(k)? Why You May Want to Re-Think That Rollover
Many executives of large firms accumulate substantial 401(k) balances during their employment. In some cases, a portion of the 401(k) may be invested in their employer’s stock. Once they choose to leave the company, by retiring, resigning, or “right-sizing”, the executive’s reflex action may be to rollover the 401(k) into an IRA. Unfortunately, by rolling over those funds, the executive has potentially negated an important tax saving concept, the Net Unrealized Appreciation, or NUA, Rule.
The NUA Rule
The NUA rule allows the employee to treat the distribution of company shares differently than the remainder of the 401(k) investments. Under this rule, only the stock’s cost basis, or purchase price, is subject to tax when it is distributed. Any gains in the stock’s share price, referred to as Net Unrealized Appreciation (NUA), is not subject to tax until it is sold. Importantly, at that time, the NUA is taxed at more favorable capital gains rates. Also, the NUA is not subject to the 3.8% Medicare surtax on investment income. For the executive in a high tax bracket, the savings between ordinary income rates and capital gains can be significant.
Hypothetical Example
Joan, a Big Pharma executive, recently retired from her company. Her 401(k) account has a balance of $1Million of which $150,000 is invested in company stock with a cost basis of $50,000. If she is not aware of the NUA rule, she may roll over the entire 401(k) into an IRA. When she withdraws from the IRA, she is subject to her ordinary income rates at that time. Since she is in the highest tax bracket, she will pay over 30% of her withdrawals in federal income tax.
As a result of her conversation with her CERTIFIED FINANCIAL PLANNER™ professional and further discussions with her tax advisor, Joan became aware of the NUA rule. Joan followed the rule’s guidelines and was able to pay the lower capital gains tax rates on the $100,000 of Net Unrealized Appreciation ($150,000 in share value minus $50,000 in cost basis). Her tax rate when she liquidated the company shares was 20% instead of the higher ordinary income rate. The tax savings paid for her retirement cruise.
Joan was able to realize significant tax savings because she strictly followed the NUA rule guidelines. If she did not, her transactions would be subject to ordinary income tax rates. So, what are these guidelines?
Guidelines for NUA Qualification
The 401(k) distribution must be a lump sum distribution.
The entire 401(k) balance must be distributed in the same year after the employee has a qualifying event. These events include separation from service, death, disability, or after he or she has attained age 59 ½.
The company stock must be issued in kind from the 401(k) plan –
A certificate of shares must be issued to the employee. If the company shares are liquidated and distributed as cash or rolled into an IRA, the NUA will not apply. However, any portion of the 401(k) balance, which is not in company shares, may be rolled into an IRA. In the example above, Joan had $850,000 of mutual funds in her 401(k). The proceeds of these funds may be rolled into an IRA to continue tax deferred growth.
When Should You Choose NUA over a Rollover IRA?
According to Putnam Investments, there are 4 scenarios where the NUA approach is preferred over a rollover IRA.[1]
- You have realized significant market appreciation in company stock within your 401(k)
- You are in a high tax bracket
- You are considering an immediate distribution
- You are leaving stock to heirs
If your goal is to defer taxes as long as possible or if you have the need to diversify your holdings because you already have too much company stock, the NUA approach may not have as much appeal as rolling your 401(k) balance to an IRA.
What Happens If Your Stock Is Worth Less Than What You Paid?
The Net Unrealized Appreciation Rule is intended to minimize taxes for “appreciated” company stock within your 401(k). What if your company stock suddenly goes down in value and is worth less than your cost basis? You can re-set your basis within the 401(k) without tax implications by selling the shares and re-purchasing them at a lower price.
Hypothetical Example
John is a VP of Human Resources for a large hotel chain. He owns 1000 shares of company stock within his 401(k) and the cost basis is $100 per share or $100,000. The COVID lockdowns severely impacted the company’s profitability causing the share price to be reduced to $50. John can sell his shares and re-purchase them at the new price. His cost basis is now $50,000. Since the sale was completed within the 401(k), no taxes were incurred.
One year later, COVID restrictions were removed and the hotel chain’s share price re-bounded to $150 per share. John decides to retire and use the NUA rule for his company stock. Because his basis has been reduced from $100,000 to $50,000, an additional $50,000 of “Unrealized Appreciation” can receive long term capital gains treatment. John uses the tax savings to pay off his home equity loan.
NUA Requires Discipline
The Net Unrealized Appreciation Rule allows shareholders of company stock held within a 401(k) to receive could be a significant tax savings benefit. However, strict rules need to be followed and accurate records are required to receive the savings. It’s very important that you have a solid financial and tax planning team behind you to maximize this benefit. Call me now so we can get started. Let’s make a plan!
Disclosures
Advisory offered through Capital Analysts or Lincoln Investment, Registered Investment Advisors. Securities offered through Lincoln Investment, Broker/Dealer, Member FINRA/SIPC. www.lincolninvestment.com
West Coast Financial Group Inc. the above firms are not affiliated.
Tax services are not offered through, or supervised by Lincoln Investment, or Capital Analysts. None of the information in this document should be considered as tax advice. You should consult your tax advisor for information concerning your individual situation.
There is no guarantee that any strategies discussed will result in a positive outcome. The views and opinions expressed herein are those of the author(s) noted and may not represent the views of The Lincoln Investment Companies. The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. Past performance is no guarantee of future results.
Before deciding whether to retain assets in an employer plan or roll over to an IRA an investor should consider various factors including, but not limited to, investment options, fees and expenses, services, withdrawal penalties, protection from creditors and legal judgments, required minimum distributions, possession of employer stock and reduction/elimination of guaranteed benefits from the pension plan.
The hypothetical examples above reflect the current tax rates, which may be subject to change.
Diversification does not guarantee a profit or protect against a loss.
[1] Putnam Investments “Understanding the NUA Rule”