Net unrealized appreciation is an underused and often unknown tax planning opportunity for those who own company stock inside a 401(k) plan.
For many of the employees that participate in an employer-sponsored 401(k) plan, the assumption is that when money is withdrawn from the plan, it will be taxed at ordinary income tax rates. For the most part and in most circumstances, this is true.
However, net unrealized appreciation may allow for a portion of the account to be taxed at preferential long-term capital gains rates.
The greater the percentage of your overall wealth that is tied up in company stock and the greater the spread between the cost basis and the fair market value, the larger the planning opportunity will be.
A Simple NUA Example
Let’s assume a hypothetical 65-year-old retiree with $1,500,000 in an employer-sponsored 401(k) plan. Lets further assume $500,000 of the total account balance is invested in company stock and that this stock has a cost basis (what you paid for it) of $75,000.
(For those who are saying there is no basis because this is all pre-tax dollars, I hear you. You are correct in saying this is pre-tax dollars. However, the company stock in the plan does have basis, which, to be fair, is often irrelevant. However, for net unrealized appreciation purposes, it becomes relevant).
In short, the retiree has a number of options, which we will try to simplify. Therefore we assume the options for this retiree, as it relates to the 401(k) plan, are as follows:
- Keep the money in the 401(k) and/or roll it over to a tax-deferred IRA.
- Use Net Unrealized Appreciation
Option 1 – Keep the Money in an IRA
If the retiree chooses option one, any and all distributions from the tax-deferred account will be taxed as ordinary income. This is very simple with very little planning opportunity.
Still, this is the most common solution.
Option 2 – Use Net Unrealized Appreciation
The second option is to take advantage of Net Unrealized Appreciation. Here is how it works:
- The retiree elects to take the company stock out of the 401(k) and directs this stock into a non-IRA brokerage account.
- When this transaction occurs, it is a taxable event and is reportable on the calendar year tax return.
- The amount taxable to the retiree is ONLY the cost basis of the company stock.
- Any capital gain in company stock (the difference between the cost basis and the fair market value) is immediately eligible for preferential long-term capital gains treatment.
- The remaining 401(k) account balance is rolled into an IRA in a non-taxable event.
The Potential Value of NUA ‒ A Tax Comparison
A simple tax calculation that compares the income tax allows us to illustrate the potential value of net unrealized appreciation.
In this example, we assume that the current fair market value of company stock is $500,000 and that the cost basis of the stock is $75,000.
We can calculate the total tax due by comparing a total distribution from an IRA versus using net unrealized appreciation. In order to do this, we need to make some simple assumptions as they pertain to tax. Specifically, we will assume the following:
- Ordinary Income Tax Rates – 33%
- Long-Term Capital Gains Tax Rate – 15%
The chart below further illustrates the details.
|Fair Market Value||Taxed as Ordinary Income||Taxed as Capital Gains||Ordinary Income tax (33%)||Capital Gains Tax (15%)||Total Tax|
In a scenario where the entire IRA is distributed and taxed at 33%, the tax liability will be $165,000.
In a scenario using NUA, assuming an immediate sale, the tax liability is $88,500.
In this simple example, net unrealized appreciation saves over $80,000 in taxes!
When This Make Sense
Certainly, it’s easy to make NUA look attractive using a hypothetical illustration as detailed above. So the question remains: “When does this make the most sense?”
There are several times when NUA may make sense:
- Highly Appreciated Stock
The bigger the spread between the cost basis and the current market value, the bigger the argument to consider net unrealized appreciation.
Simply put, the larger the capital gain, the larger the opportunity to pay capital gains tax in lieu of ordinary income tax. Paying 15% in lieu of paying 33% can lead to major tax savings.
- Large Spread in Tax Brackets
Tax brackets change based on levels of income for both ordinary income tax and capital gains tax. The larger the spread between the two, the greater the opportunity will be to utilize preferential long-term capital gains treatment.
- Greater Percentage of Your Account Value
The larger the percentage of your account value, the greater the opportunity will be.
- When Seeking to Lower RMDs
Diversification* is a common term that is used when it comes to investing. In short, it simply means don’t have all your eggs in one basket.
As it pertains to retirement planning, diversification can mean having different types of assets in retirement, more specifically, taxable, tax-deferred, and tax free.
Using net unrealized appreciation can be a strategy that takes tax-deferred income and makes it taxable. Since the portion of your assets that is subject to NUA are no longer in an IRA or 401(k), the account value will not be included in the RMD calculation. This transaction has the net effect of lowering RMDs in retirement.
It may also allow for greater tax planning with Social Security and other retirement income distributions.
What It Takes to Qualify
There are many rules for net unrealized appreciation, and they need to be followed explicitly to be sure you receive the benefit you are seeking. Specifically, the rules are as follows:
- You must distribute your entire account balance from all employer plans within one year.
- You must take the distribution of company stock as shares.
- You must have completed one of the following:
- Be age 59½
- Separated from service
- Become totally disabled (if self-employed)
If you think net unrealized appreciation is something you would like to consider, it makes sense to speak with an expert who can help you sort through the details so that you can determine how big the spread between the cost basis and fair market value is and how NUA fits into your overall financial plan.
Implemented appropriately, net unrealized appreciation may lower your overall net tax liability, therefore leaving you with more cash in your pocket.
*Diversification does not guarantee a profit or protect against a loss.
Tax services are not offered through, or supervised by Lincoln Investment, or Capital Analysts.
None of the information in this document should be considered as tax advice. You should consult your tax advisor for information concerning your individual situation.