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Lowering Taxes With Net Unrealized Appreciation - Pinnacle Investment Management, Inc.

Lowering Taxes With Net Unrealized Appreciation

August 21, 2017 / Blog

If you have employer stock in your 401(k) you may be able to take advantage of the rules regarding Net Unrealized Appreciation (NUA), which can help you get favorable tax treatment and potentially save quite a bit on taxes.


To understand the potential value of NUA, let’s first look at the traditional options someone has when they take money from their 401(k).

When you leave employment you have the option of rolling your 401(k) to an IRA. This transfer is a nontaxable event. However, when you subsequently take money from an IRA, the distribution is treated as ordinary income. For instance, if you are in the 25% marginal tax bracket and take out $25,000, you will owe $6,250 in taxes.

Another option is to take your 401(k) and move it into a regular taxable account (non-IRA account). If you did this you would pay taxes on the entire amount. In most instances this is not a great idea.

A third option brings us to the NUA rules, in which case you would move the employer stock to a regular taxable account and the rest of the account to an IRA.


What is NUA

NUA, which only applies to employer stock in your 401(k), is the difference between the current value of your stock and the purchase price of the stock.

Terry works for ABC Company. In his 401(k) he has $100,000 worth of ABC stock, with a cost basis of $10,000. His NUA is $90,000.

If you decide to use NUA, you move the employer stock over to a taxable account, which is considered a distribution and so is a taxable event. However, you wouldn’t pay taxes on the entire amount moved over. Rather you  would only pay taxes on the basis of the stock!  The NUA (the gain in the stock) isn’t taxable immediately, and most importantly, when you do sell it, it will be taxed at the favorable long term capital gains rate instead of as ordinary income.

If Terry moved over the ABC stock to a taxable account, he would only pay tax today on his basis of $10,000. The NUA of $90,000 wouldnt be taxed until Terry sells the stock, at which time it would be subject to favorable capital gains treatment.


Example of NUA

Let’s look at another, more complete example to see the full benefits of NUA.

Janet has a 401(k) valued at $500,000. Of that, $150,000 is in her company stock, with a basis of $30,000. Her NUA is $120,000.

Janet has a few options. First she can roll over the entire account to an IRA. Whenever she takes money out she will owe taxes at her marginal bracket of 25%.

Another option for Janet is to take advantage of NUA rules and roll the $150,000 of stock to a regular taxable account and the remaining $350,000 to an IRA. She would pay ordinary income tax today on her basis of $30,000. However the $120,000 of NUA is eligible for favorable capital gains treatment. She doesn’t have to sell the stock right away. She can hold it for as long as she wants. Even if Janet does sell it right away, it will still be treated as Long Term Capital Gains, which would be taxed at the 15% rate. There is no holding period requirement for the NUA.

This is how the math would look: If Janet elects NUA, she would pay $7,500 in taxes today (25% income rate x $30,000). On any subsequent sales of stock she would pay 15% capital gains tax. 15% of $120,000 is $18,000. Her total tax would be roughly $25,500.

If Janet elects not to take advantage of NUA and instead rolled the entire 401(k) into her IRA, then $150,000 of subsequent withdrawals would be taxed at 25% marginal tax rate, which roughly equals $37,500.

By electing NUA, Janet can save roughly $12,000 in taxes!


NUA Rules to Be Mindful of:


• You can only elect NUA after a triggering event, which includes death, disability, separation from service or after reaching age 59.5. Most likely you will elect NUA after you are retired.

• If you choose to utilize NUA you must roll over the entire 401(k) in the same year. You cant just roll the stock to a taxable account and keep the rest of your account in the 401(k). Rather, at the end of the year there must be nothing left in your 401(k).

• When you roll over the company stock to the taxable account it is considered a distribution. So you have to pay ordinary income tax like we discussed, but you also would have to pay a 10% penalty if you are under the age of 55. If you younger than 55 I would recommend waiting until you turn 55 to do the rollover.

• You don’t have to elect NUA for all of the employer stock. Rather you can elect to treat a portion of the stock as NUA, and roll over the remaining stock to the IRA.

• In your 401(k) you may be able to check the basis of each lot of stock you own. You may have low basis for stock that was purchased early on in your career and much higher basis for stock purchased more recently. You could elect to roll over the lower basis stock to a taxable account (and elect NUA) and roll over the high basis stock to your IRA.


Thoughts and Considerations


• NUA is generally advisable in instances where your employer stock has grown considerably. If it hasn’t and you don’t have much NUA, then it may not make as much sense. It is worth doing a calculation to see how it would play out in your specific situation. Michael Kitces at Nerd Eye View has an excellent article on this.

• An added advantage of NUA is that the amount rolled over into the taxable account won’t be subject to Minimum Required Distributions, since it isn’t in an IRA. In the example of Janet above, her IRA balance will be $350,000 if she elects NUA, rather than $500,000 if she rolls over all of it to her IRA. If she did roll it to the IRA, at 70.5 her MRD will be larger since her account balance is larger.

• A potential disadvantage of NUA is that it is not eligible for a step up in basis when you pass.


NUA can be an excellent tool and it can help you save a substantial sum in taxes. But like most things tax related, you must first understand the rules and how it fits into your personal financial situation.

About the author

John Shanley: CFP ® is a Financial Advisor with Pinnacle. He joined in 2015 after previously working as a Financial Consultant for Fidelity Investments. John is a Certified Financial Planner, a graduate of Fordham University and is currently pursuing his Masters degree in Financial Services. John is a native of Pawling NY and currently resides in Suffield with his wife, Jennifer, who is an Immigration Attorney. In his free time, John enjoys reading and is an avid hockey fan.

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