How to Use Net Unrealized Appreciation (NUA) for Tax Savings with Employer Stock in Your 401(k)

If you own your employer’s stock in your retirement plan and change jobs, don’t be too quick to roll that account into an IRA. If you do, you may lose one of the best tax benefits available to high wage earners.

Hi, I’m Chuck Lewandowski, CERTIFIED FINANCIAL PLANNER™ professional. Before I entered the financial services field, I worked for a large health care company that offered some of the best employee benefits available. The opportunity to purchase company stock in the 401k account was included in the benefit package.  Like many people, I purchased the stock over several years. I then rolled over my 401k account into an IRA when I left the company. Little did I know that I left some substantial tax savings on the table. If I was aware of a concept called Net Unrealized Appreciation or NUA, I might have saved quite a bit of taxes. Today, I would like to discuss the mechanics of the NUA process so you can have a meaningful discussion about its benefits with your tax advisor.

Employer Stock in 401(k) and ESOP Accounts

Many companies allow employees to purchase company stock in their 401k accounts. This includes well known large companies such as Johnson & Johnson, Microsoft, and WalMart. It also includes smaller companies that have an Employee Stock Ownership Plan, sometimes known as an ESOP. If you purchase company stock in either of these retirement plans, NUA allows you to sell your shares at favorable capital gains rates versus the normal ordinary income rate that you would typically pay by liquidating a portion of your IRA. This works especially well if you have a great deal of appreciation in your company stock. However, there is a very strict sequence of events that must be followed, or you will lose the NUA opportunity.

How Does NUA Work?

Here’s an example to illustrate the process.

Let’s assume that Joe worked for twenty years at one of the large tech companies that I mentioned earlier. Joe was a dedicated saver who contributed to his 401k account regularly, A portion of these savings purchased shares of his employer’s stock. When Joe retired, his company shares were worth much more than he had paid for them. Here are the numbers.

401k account value at retirement – $1,500,000

Value of Joe’s company stock at retirement – $850,000

Cost of Joe’s company stock $100,000. This is called the basis.

As you can see, Joe had a nice $750,000 gain in his company stock. This gain is the Net Unrealized Appreciation (NUA). If Joe follows the NUA process and sells his company stock, he will be taxed at the favorable capital gains rates instead of ordinary income rates.

Mistake To Avoid

To receive the NUA tax treatment, Joe cannot rollover his entire 401k account to an IRA. He needs to transfer his company stock “in kind” to a taxable brokerage account. He cannot sell the stock and transfer the funds or the NUA treatment will be lost. The actual shares need to be transferred to a new taxable account. The remaining portion of the 401k can be rolled over into an IRA but that must happen within the same year or, once again, the NUA treatment is lost.

What IS The Tax Impact?

So how does the tax treatment work in this scenario? If Joe follows the required steps, he will pay ordinary income taxes on the $100,000 cost basis of the company stock. But, the remaining gain of $750,000 will be taxed at capital gains rates even if he sells the shares one day after he transfers them to the brokerage account. If necessary, he can sell some of the shares at a more favorable rate to pay the tax liability.

If Joe had rolled over the entire 401k account into an IRA, he would be subject to ordinary income tax rates when he withdraws during retirement.

Let’s say that Joe held onto the shares and the value increased an additional $200,000. How would Joe be taxed then? It will depend on how long he holds the shares.

Cost basis of $100,000 – Ordinary income tax rate at time of NUA exercise

NUA amount of $750,000 – Capital Gains tax rates

Additional gain of $200,000 – If less than 1 year, ordinary income tax rates

• If over 1 year, capital gains tax rates.

The example that I’ve shown assumes that your shares can be readily accessed to create the NUA opportunity. If you have shares in a private company or an Employee Stock Ownership plan, the ability to receive the shares “in kind” may be limited resulting in a more complicated process.

Get A Knowledgeable Partner

The Net Unrealized Appreciation process should not be attempted without the guidance of a competent tax professional. Although it’s complex, the value of the end result more than offsets the effort to complete it. If you are looking for advisor to work with your tax professional on this effort, please give me a call and Let’s Make a Plan.

Disclosures

This hypothetical scenario is provided for general information and educational purposes only and should not be construed as investment, tax, accounting, or legal advice. It is strongly recommended that each individual meet with their own tax advisor who can address his/her specific situation.

Advisory services offered through Capital Analysts or Lincoln Investment, Registered Investment Advisers. Securities offered through Lincoln Investment, Broker-Dealer, Member FINRA/SIPC. www.lincolninvestment.com

West Coast Financial Group, Inc. and the above firms are independent and non-affiliated. Tax services are not offered through, or supervised by, The Lincoln Investment Companies.