If you work for a publicly traded company, chances are you can own company stock inside your 401(k) retirement plan. We’ve seen many workers nearing retirement who have accumulated substantial shares of company stock. These workers are often unaware that they have an option with the tax treatment of these shares that could potentially result in substantial tax savings.
The option these workers have is to use the Net Unrealized Appreciation (NUA) strategy. Normally upon retirement, assets distributed from a 401(k) or an IRA are taxed at ordinary income rates as high as 37%. However, only for company stock, you can elect NUA treatment and have the gain on shares taxed at long-term capital gains (LTCG) rates, which max out at 23.8% for the highest income earners. A 13%+ reduction in taxes on gains is enticing, so let’s examine how this strategy works.
Upon retirement or separation of service, the worker removes the entire balance of their 401(k). The non-company stock is rolled over to an IRA and the company stock is distributed to a taxable account. To perform this transaction, they must work with the retirement plan to keep the cost basis of the company stock and distribute actual shares, not liquidated cash. Distributing the company shares causes a taxable event and ordinary income tax must be paid on a cost basis. The shares can then appreciate being sold at LTCG rates.
Before we look at a case study outlining the potential benefits of using NUA treatment, let’s look at some particulars of the strategy. Several different factors make this a very individual decision*.
- Only works if company stock is appreciated: Ideally, shares are worth 2x cost basis or more. If the stock declines, this strategy can be a net negative.
- Works best for high-income earners: The spread between ordinary income and capital gains tax rates is smaller for low-income earners and this strategy is less attractive.
- Generates a tax bill: Electing NUA treatment generates income on a cost basis, so you’ll need to plan to have the cash to pay the initial tax bill.
- Works best with long time horizon: Tax-deferred growth and avoiding required minimum distributions enhance this strategy over longer periods.
- Dictates your asset allocation: You must continue to hold company stock in retirement.
Carol is a branch president for a large bank and has purchased company shares in her 401(k) for years. The shares are worth $200,000 and have a cost basis of $50,000. Her high income and ownership of rental properties will keep her in a high tax bracket indefinitely. If she elects NUA treatment, she pays a federal tax of $18,500 next April. If she sells the shares in ten years for $200,000, she saves $43,000 in tax. If she didn’t use NUA treatment, she would have had to earn over 8% of the cash she used for the tax payment to break even. If the stock had appreciated, every dollar earned would have increased her savings by 13.2 cents.
*This discussion is not meant to be construed as investment advice or personal financial planning advice. Some rules and transactional steps have been omitted for brevity; this is not a handbook for implementation. This strategy depends on many variables such as income level, investment horizon, cash flow, risk tolerance, economic environment, and firm-specific risks. Please consult us for an individual discussion to see if this strategy may be right for you.