If you are accumulating employer stock in your 401(k) and the value continues to go up….congratulations! With such a nice nest egg, you need to implement the most tax efficient strategy for liquidation. After all, the lower your taxes, the more funds you have to spend in retirement.
As hiring and retaining talented employees becomes more and more competitive, it is not uncommon to see employers issue stock to their employees as an incentive. Due to this growing trend, it is also common to see individuals with a high concentration of employer stock within their sponsored retirement accounts.
While these accounts are great retirement vehicles and can provide for tax benefits before retirement, the downside is that distributions from these accounts are taxed as ordinary income in retirement. Fortunately, there are strategies you can utilize to mitigate these tax bills. One of those being Net Unrealized Appreciation (NUA).
What is NUA?
NUA is a strategy that allows individuals to distribute employer stock from their employer sponsored retirement accounts into a brokerage account while only paying tax on their cost basis. This works really well when the employer stock has appreciated in value. The alternative is to take distributions throughout retirement and paying income tax on each distribution.
The primary advantage of NUA is that the owner only pays short or long-term capital gains taxes on those shares once sold within the brokerage account. Short-term capital gains are taxed at the individual’s ordinary income tax rate, but long-term gains are taxed much more favorably, often between 0% and 20%. Another advantage is that by moving assets from tax-deferred accounts into taxable accounts, their future required minimum distributions will be reduced.
As an example, let’s say John is 60 and has a 401(k) worth $1,000,000 containing employer stock worth $400,000 and a basis of $100,000. If John properly elects NUA, he will owe ordinary income tax on $100,000 while moving $300,000 in gains from a tax-deferred account into a taxable account.
A year down the road John decides to retire and thus has no source of income. If he needed $100,000 and did not elect NUA, that entire amount distributed from his 401(k) would be taxable and place him in the 22% tax bracket. If he elected NUA, he could liquidate some of those shares in his brokerage account and would only pay 15% in long-term capital gains taxes on a portion of that amount liquidated.
As you can see, NUA can have great benefits. But do you qualify?
Requirements to Elect NUA
There are three primary requirements that must be met in order to take advantage of NUA.
First, a triggering event must occur. Triggering events include separation from service, death, disability, and attaining age 59 ½. Once you meet one of these events, your NUA eligibility begins. Please note that NUA does not have to be elected in the same year that a triggering event occurs.
Second, this provision only applies to tax-deferred accounts. If you have employer stock in a Roth 401(k) for example, NUA cannot be elected.
Third, you must take a lump sum distribution of the account meaning that the account must be completely empty by the end of the calendar year.
As long as those three requirements are met, NUA can be elected.
When Does NUA Make Sense?
Just because you can elect NUA does not automatically mean that you should. Generally speaking, NUA makes sense when you have a concentration of employer stock that has appreciated, and you expect will continue to appreciate in the future. Additionally, it doesn’t make much sense to elect NUA and then sell any shares within a year. These proceeds will be taxed at the same rate as your income. The benefits of NUA are best felt through the more favorable long-term capital gains rate that comes with holding shares for more than a year.
Furthermore, given that ordinary income tax is owed on the cost basis, it makes sense to employ this strategy in years of lower income such as those just after retirement and before required minimum distributions commence.
Summary
If implemented properly, NUA can have benefits that will positively impact your situation for years. However, careful consideration should be given to whether you can make this election and whether the possible benefits outweigh the present-day costs. Consulting with a financial planner and your tax professional is recommended in order to properly analyze the pros and cons associated with Net Unrealized Appreciation.
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We have helped our clients answer these questions and more. If you want a clear understanding of your financial future, and need help making changes to reach your goals, schedule a consultation and we can get started.
The material has been gathered from sources believed to be reliable, however Bedel Financial Consulting, Inc. cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. To determine which investments or planning strategies may be appropriate for you, consult your financial advisor or other industry professional prior to investing or implementing a planning strategy. This article is not intended to provide investment, tax or legal advice, and nothing contained in these materials should be taken as such. Investment Advisory services are offered through Bedel Financial Consulting, Inc. Advisory services are only offered where Bedel Financial Consulting, Inc. and its representatives are properly licensed or exempt from licensure. No advice may be rendered unless a client agreement is in place.
