Net unrealized appreciation (NUA) can be a great tax-saving opportunity for those who have highly appreciated employer stock within their employer-sponsored retirement plan.
In basic terms, NUA refers to the difference between the original cost basis of employer stock held in a retirement plan and its current market value. For example, let’s say Jeff works for XYZ company and has $300,000 worth of XYZ stock in his company 401(k). The stock is worth $300,000, but he has worked for XYZ for a very long time, and his cost basis for the stock is only $25,000. The difference between those two numbers ($275,000) is the net unrealized appreciation.
Where things get exciting is the fact that this $275K NUA figure can receive special tax treatment. If handled correctly (more on that below), Jeff can pay long-term capital gains taxes on the growth of these shares of employer stock versus ordinary income rates, which is the standard tax treatment for tax-deferred dollars held in an employer retirement plan.
Paying long-term capital gains rates is far preferable to ordinary income tax rates. A scenario like the one listed above can potentially save tens of thousands of dollars in taxes on the dollars held in this employer plan.
Look at the below example to visualize the potential tax savings:
As you can see, NUA offers some potentially massive tax savings on highly appreciated employer stock held within a 401(k). The strategy that utilizes NUA saves Jeff nearly $20,000 in total taxes owed on these shares of employer stock.
So, What’s the Catch?
While there isn’t a true “catch,” there are some risks and potential drawbacks to be aware of. First, to be a candidate for special tax treatment of NUA, you need a substantial, highly appreciated position in your employer stock within your employer retirement plan.
This lack of diversification can expose you to excess volatility risk, which can work both ways (up and down). Poor performance on the part of your employer stock can hinder the long-term value of NUA as a strategy. Conversely, the outsized performance of your employer stock makes the NUA strategy even more attractive. Beware, that pendulum swings in both directions.
Second, I will stress that this is a complex tax strategy and should not be done without professional guidance. Consult with a CPA before attempting to utilize NUA with your employer stock.
Mechanics: How NUA Works
Assuming you have highly appreciated employer stock within your 401(k), there are a few steps to properly utilize NUA.
First, you need to have a “triggering event.” Triggering events include death, disability, separation from service (commonly retirement), or reaching age 59.5. Note that if you attempt NUA before age 59.5, you can be charged a 10% early-withdrawal penalty on the shares distributed from the 401(k), unless you are 55 or older and retired.
Second, you must distribute the shares of employer stock in-kind to a non-retirement brokerage account. If you sell the shares while they’re still in your 401(k), you will lose your NUA opportunity. They must be distributed in-kind to the brokerage account before selling.
Third, you must distribute your entire 401(k), emptying it completely. You need to move the company shares to a non-retirement brokerage account and the remaining 401(k) dollars into an IRA. None of it can stay in the 401(k).
To summarize, to utilize NUA, you must:
1. Have a triggering event.
2. Distribute the employer stock in-kind to a non-retirement brokerage account.
3. Distribute the entire account as a lump sum. It must be the whole account, not just the shares of company stock.
Once you have completed these three steps, you can utilize NUA to receive long-term capital gains tax treatment on these shares of company stock. Whether you sell these company shares immediately or hold on to them, you will always receive long-term capital gains tax treatment on them.
Any subsequent gain or loss on these shares will be taxed (short or long term) based on when the shares left the employer plan.
As a reminder, NUA is a sophisticated and complex financial planning and tax savings strategy. This strategy is likely not for DIYers, as it requires careful planning and awareness of the tax rules and code. Consult with your CPA and financial planner before attempting to utilize NUA with your appreciated employer stock owned within your company 401(k).