For employees working at a publicly traded company, you may have an option to buy the stock of the company you work for within the 401k plan. While making the decision to invest in that stock is a decision within itself, simply due to the risk associated with investing in the company that also provides you with a paycheck, it can have substantial tax rewards if that stock appreciates.
What is Net Unrealized Appreciation?
NUA refers to the difference between the stock’s value at the time it was distributed from the retirement plan and the price originally paid for the shares. This unrealized gain amount can be assigned different tax treatments for tremendous potential tax savings.
How the NUA Strategy Works
Rather than taking the entire 401(k) balance as a lump sum distribution, which would be fully taxed as ordinary income, the NUA approach involves taking just the employer stock shares through a lump sum distribution while rolling over the remaining assets into an IRA.
The embedded NUA in the distributed employer stock is then taxed at long-term capital gains rates (currently 0%, 15%, or 20% depending on income), which are generally much lower than ordinary income tax rates. Any subsequent appreciation after taking the lump sum is also taxed favorably as a capital gain when sold.
The Potential NUA Tax Savings
To illustrate the benefit, consider this example of an employee retiring at age 65 with $1 million in their 401(k), which includes $400,000 worth of employer stock purchased at $100,000 originally.
By taking the full $1 million distribution, they would owe approximately $370,000 in taxes assuming a 37% ordinary income tax rate.
However, using the NUA strategy:
- Only the $300,000 cost basis of the remaining 401(k) is taxed at 37%
- The $300,000 embedded NUA gain is taxed at 20% long-term capital gains rate
This results in total taxes of around $191,000 – a savings of $179,000 compared to the full distribution!
Important Considerations
The NUA strategy tends to produce the most benefit for individuals with highly appreciated employer stock holdings and who expect to be in a high marginal tax bracket in retirement. However, it also comes with some additional complexity such as eventually owing taxes on the NUA amount when selling the shares later.
For many employees and retirees holding concentrated single stock positions within retirement accounts, taking the time to understand and potentially utilize the NUA provision could lead to substantial tax savings over the long run. As always, it’s wise to consult a qualified tax professional before making any distribution decisions.
Presented by the Financial Planning Committee of Lake Street, an SEC Registered Investment Adviser
The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not intended to be a client-specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. Diversification does not ensure a profit or guarantee against a loss. There is no assurance that any investment strategy will be successful. Investing involves risk and you may incur a profit or a loss.
