When leaving a job for whatever reason, one of the biggest decisions you will face is what to do with your 401(k). If your plan includes shares of your company's stock, NUA is something to consider during this process.
The Basics of NUA:
- Net Unrealized Appreciation (NUA) can provide a significant tax break for those holding low-basis employer stock in their retirement plan.
- There are strict rules that must be followed to take advantage of the NUA option.
- NUA can provide an additional level of planning flexibility.
WHAT IS NUA?
NUA is the difference between the cost basis (what you paid) of any company stock held in your 401(k) and its current market value. Normally cost basis doesn’t matter for securities held in a qualified retirement plan, but NUA is a little-known exception within the tax code.
When rolling over your 401(k) account, NUA allows you the option of rolling the stock into a taxable account and the rest of the account’s assets into an IRA to preserve the tax-deferral on those assets. Those other assets might include mutual funds or other types of pooled investments offered within the plan.
Under NUA the cost basis of the employer stock is taxed upon distribution. The gain over and above the cost basis would remain untaxed until the shares are sold. They will qualify for preferential long-term capital gains rates if the shares are held for at least a year from the date of distribution from the 401(k). If you are under 59 ½ a 10% penalty could also apply. Note if you are eligible for the age 55 exemption this penalty may not apply.
WHAT ARE THE RULES FOR NUA?
To qualify for NUA treatment, there are four criteria all of which must be met:
1. The entire balance must be distributed: The entire vested balance of the qualified retirement plan must be distributed within one year of the initial distribution.
2. All assets from your retirement plans must be distributed: All assets from all qualified plans with this employer must be distributed, even if only one of the plans (if there are more than one involved) holds shares of company stock.
3. Company stock must be distributed in-kind: The shares of company stock must be distributed in-kind (not converted to cash prior to the distribution). You can pick and choose which shares of company stock will receive the NUA treatment, but those shares must be delivered in-kind. The rest of the shares can be rolled to an IRA along with any other assets from the retirement plan.
4. A triggering event must occur: The distribution must be triggered by at least one of the qualifying triggering events.
- Separation from service from the company in whose retirement plan the company shares are held.
- You’ve reached age 59 ½
- You become totally disabled
The IRS is strict about these rules. Not adhering to the rules can disqualify the NUA transaction resulting in a higher tax than anticipated.
HOW NUA WORkS
Before rolling your 401(k) funds over, be sure to open both an IRA Rollover and taxable investment account at your chosen custodian.
Be sure that the shares of the company stock for which you are intending to use the NUA option are transferred to the taxable account in-kind.
The rest of the money in the 401(k) account would be rolled to the IRA account just like any other 401(k) rollover where there is no company stock involved.
In all cases you will want to ensure to utilize a trustee-to-trustee transfer. If you take possession of the tax-deferred funds your employer has to withhold 20% of the amount. This could cause you tax headaches if the process is not handled correctly.
WHEN NUA PROBABLY MAKES SENSE
If you hold company stock in your 401(k) plan, NUA can make sense under several circumstances:
- There is a large differential between the cost basis of the stock and the current market value: The larger the difference, the more valuable the advantage of the preferential long-term capital gains rates.
- There is a large differential between your ordinary income tax rate and the capital gains tax rate: The larger the differential between your current tax rate on ordinary income and the capital gains rate the more beneficial the use of NUA.
- You hold a high percentage of your investments in tax-deferred retirement accounts: Using NUA offers a good opportunity to diversify the tax treatment of your investment portfolio. None of us knows the direction of tax laws in the future.
WHEN NUA MAY NOT MAKE SENSE
NUA may not make sense in some other situations:
- There is a small differential between the cost basis of the stock and the current market value: If the appreciation on the stock is rather minimal, or if its value is less than your cost it probably isn’t beneficial to use NUA. That said, certainly the stock could appreciate in the future.
- The cost basis of the stock would represent a significant tax liability for you: If the cost basis of the stock is a significant amount, the tax might be sizable. This could push you into a higher tax bracket for ordinary income in the year of the transaction. As with any financial transaction, you will need to crunch the numbers to see if there is a genuine benefit.
Some advisors think that the NUA approach may have less benefit if the shares are held over a long period of time once they are rolled out of the retirement plan. We feel the decision whether to sell a concentrated stock position should be based on each investor’s unique situation.
Jane is 58 years old and served as VP and division controller at her employer, a large publicly traded company. The stock has experienced solid appreciation over the years. She is leaving to take a position at another company. She and her husband work with a trusted financial advisor. They want these assets managed in line with the rest of their portfolio under advisement with the advisor. The majority of the $2.5 million already under advisement is held in tax-deferred retirement accounts.
Her $750,000 401(k) is invested as follows:
- $450,000 divided among five mutual funds
- $300,000 in shares of company stock with a cost basis of $50,000
If Jane rolls the entire amount to an IRA, it will all be subject to taxes at her ordinary income tax rate when she plans to withdraw it during retirement. While tax rates are generally lower in all tax brackets under the new tax rules passed at the end of 2017, she is still likely better off paying taxes at the lower capital gains rates.
Let’s assume Jane and her husband will be in the 32% tax bracket until retirement and at least the 22% tax bracket in retirement, when their income will include pensions, Social Security, and distributions from their retirement accounts.
- Her taxes on the $50,000 cost basis in the stock will be $16,000 at current rates.
- If she holds the stock for at least a year and then sells, the capital gains will be taxed at 15%. This is still lower than their 32% marginal tax rate on ordinary income while they are working or their anticipated 22% marginal rate in retirement. State income taxes will be due on any capital gains.
The potential benefits of using NUA extend beyond the potential tax savings. Since the majority of their retirement savings are in tax-deferred plans like 401(k)s and IRAs, using NUA allows the couple to diversify the tax profile of their holdings.
This is important because none of us knows the future direction of tax rates. Most of the tax savings provisions of the new tax laws are set to expire after 2025. Many experts feel that tax rates will increase after that time due to the large deficits that are likely under the new tax rules.
NUA offers those with company stock in their 401(k) plan an option to consider when leaving their company. The ability to distribute the stock in-kind to a taxable account can be beneficial as a planning tool.
NUA is complex and not advantageous in every case. Everyone’s situation is different. If this is an option for you, please give us a call to discuss. We can help you assess the situation and recommend the best course of action for your unique situation.