Does your 401(k) account include shares of your employer’s stock that have grown a lot since you acquired them? If so, you may be able to make use of a “net unrealized appreciation” (NUA) strategy when you retire or otherwise leave your employer.
To better understand it, NUA is the difference between the market value of your company’s shares on the date they are distributed to you and the date they were originally added to your plan account. In general, to use the NUA strategy, you have to: Leave your company, receive a lump-sum distribution of your account’s entire balance in a single year, and choose to take all or some of your company stock “in kind.” That means you take the actual shares instead of a distribution check for their value, rolling them into another employee plan, or rolling them over into an individual retirement account (IRA). This requires a transfer of shares received to a taxable brokerage account and not a roll over into an individual retirement account or qualified plan.
Taking your shares “in kind” creates a three-way withdrawal. First, you take a distribution and pay tax on the stock at your ordinary-income rate based on the cost basis from the 401(k). But you pay tax only on the cost basis, not on the NUA. Taxes that are due on the “in kind” transfer should be paid with non-retirement account monies to optimize this strategy. Ideally, this strategy works better for distributions after age 59 ½. The NUA will be taxed when you or your heirs sell the shares.
Second, when you sell, you pay the tax on the NUA at the long-term capital gains rate even if you do not hold the stock otherwise required for the long-term capital gain treatment. For appreciation in excess of the NUA, the gain can be taxed as short-term or long-term depending on the holding period after the date of distribution. Currently, the maximum rate on long-term capital gains (15% or 20%) is lower than the maximum rate on ordinary income or short-term capital gains (37%). In addition, realize that capital gains rates are subject to change in the future.
Third, distributions before age 59 ½, may be subject to an early 10% withdrawal penalty. The penalty should apply only to your cost basis, not to the NUA.
By taking the company stock, you are exposed to market risk and may have the potential for a loss. Market risk is the exposure to the uncertain market value of the stock, the potential for a holder to experience losses from the fluctuations in a stocks price.
You also need to consider your asset allocation from holding the company’s stock. When deciding what to do with company stock, focus on your total portfolio’s investment objectives, asset allocation and the company’s prospects. The rationale is that an “in kind” transfer may raise your portfolio's risk and volatility, making it riskier, at a time when you probably want to reduce risk. If you take the company stock as shares, you may have to adjust your retirement portfolio's asset allocation to help keep its risk level in check.
Also, there may be an Unearned Income Medicare Contribution Tax of 3.8% that applies to net investment income for taxpayers whose modified adjusted gross income exceeds $200,000 (for single filers) and $250,000 (for married filing jointly). Thus taxpayers in the highest tax bracket could face a combined 40.8% marginal tax rate on certain investment income (e.g. short term capital gains). In addition, the stock’s appreciation after distribution may be subject to the Medicare Contribution Tax (3.8%), however, the NUA portion of the gain is not subject to such additional tax.
What would happen if you follow the usual advice to preserve your tax deferral by rolling over your retirement plan distribution to an IRA? All distributions from an IRA are taxed as ordinary income. So, including your company stock in the rollover means losing the capital gains rate advantage for its NUA. Remember though, once you “rollover” the stock to an IRA, you lose the NUA opportunity!
Also, at age 70½, you must begin required minimum distributions from an IRA. In general, you can hold your stock indefinitely.
Here’s a simple example of an NUA strategy. Assume you’re age 64 and planning to retire soon. You expect to be in the 35% tax bracket after you retire. (15% long term capital gains rate.) You have a $600,000 balance in your 401(k) account — $400,000 in your employer’s stock with a cost basis of $100,000 and the rest in a mutual fund.
If you take the $400,000 worth of stock “in kind” when you retire and roll over the $200,000 into an IRA, you’ll pay approximately $35,000 federal income tax on the $100,000 cost basis of the stock. But you’ll defer all the taxes on the $300,000 NUA until you decide to sell the shares (and on the $200,000 IRA until you take voluntary distributions or required minimum distributions). When you sell your stock, you’ll pay the applicable capital gains rate in effect then on both the NUA and any appreciation that occurs after the distribution. Depending on the facts and circumstances the appreciation that occurs after distribution could also be subject to the Medicare Contribution Tax (3.8%).
If you roll over the entire balance into an IRA instead, you won’t pay any taxes immediately. Again, you lose the NUA opportunity once the stock is deposited into the self-directed IRA. Eventually you’ll pay up to 35% (or your ordinary income rate then if different) of every dollar distributed from your IRA, and you’ll have to eventually take required minimum distributions.
Based on our example, assuming no appreciation, you could gain approximately 20% (the difference between the current federal ordinary income tax and capital gains tax) of the NUA or $60,000. Depending on what state you live in, your state and/or local taxes could be affected as well.
The tax rules for retirement plan distributions are complicated. So, ask your professional advisors for help before you make a decision to take your 401(k)’s withdrawal or arrange for a rollover.