Must Read if You Own Company Stock in a 401(k) or other Corporate Retirement Plan
The Net Unrealized Appreciation (NUA) Tax Strategy:
If you work for a corporation that offers company stock inside a 401(k), ESOP, or profit sharing plan, the Net Unrealized Appreciation tax planning strategy (described below) can produce substantial tax savings. This is especially true for long-time employees possessing stock that has appreciated significantly.
Net Unrealized Appreciation (NUA) is defined as the difference between the original cost basis of the company shares (the amount you invested) and the current market value. It is section 402(e)(4) of the Internal Revenue Code. Under normal circumstances, when you distribute money from a 401k, you will pay ordinary income tax at your current rate on the entire distribution. By utilizing this NUA strategy, you can potentially convert all unrealized gains in the stock (current value minus original investment) to a lower capital gains tax rate. If the stock you own in the retirement plan has increased substantially in value, you only pay the ordinary income rate on the original pre-tax amount you invested, while all of the asset appreciation is taxed at a lower capital gains rate.
Rather Than Ordinary Income Tax, Pay Lower Capital Gains Tax
Using this strategy, you will pay ordinary income taxes on the cost basis (original investment) of the distribution, upfront. However, if your stock has appreciated considerably, the tax savings on the entire amount can be significant. For example, if you hold company stock that you purchased for $250,000 and appreciated to $1,000,000, you end up with the following: $250,000 would be taxed initially at your current ordinary income tax rate. The remaining $750,000 would be transferred to a brokerage account where you would hold the stock until you decide to sell it. At the time of sale (all or a portion), you would be taxed at the lower capital gains rate, conceivably saving as much as 13% on the gain, or as high as $97,000 on the total! Additionally, if you hold the stock until death, your beneficiaries will receive a step-up in basis and never pay taxes on the appreciated value.
One additional note: people who have worked for a company for many years usually have original share purchase prices which vary from low to high based on the market price at the time of the purchases. Fortunately, NUA rules allow for partial distribution. So in this case, you could cherry pick the lower cost basis shares for the NUA distribution and roll the remaining high cost basis shares into an IRA.
Bottom line: if you own company stock that has appreciated in a retirement plan, we can do the analysis and determine how much this NUA strategy will benefit you.
AUTHOR: Rob Taylor