Net Unrealized Appreciation (NUA) Retirement Planning & Tax Optimization

Written by: Patrick Marcinko, CFP® | Bogart Wealth

Net Unrealized Appreciation (NUA) – What is it?

Net Unrealized Appreciation (or “NUA”) is a tax planning strategy that provides potentially favorable tax treatment if you have employer stock in a qualified retirement account, like a 401(k). Typically, when you withdraw money from your 401(k), the amount withdrawn is subject to ordinary income rates. Regardless of the gain or loss on the investments in your 401(k), any dollar that is taken out is taxed as ordinary income.

This is where NUA comes into the equation. NUA allows you to distribute all your employer stock to a brokerage account where you will be taxed on the cost basis of those shares at ordinary income rates. While you don’t avoid ordinary income rates altogether, the tax benefit of declaring NUA is that it defers paying additional taxes until the stock is sold. When you decide to sell NUA shares in the future, the difference between the sales price and cost basis is taxed at capital gain rates. Declaring NUA can lead to tax savings compared to selling employer stock and withdrawing the proceeds from an IRA.

Who might benefit the most from declaring NUA?

If you have been saving in your 401(k) and investing in your employer’s stock, you may want to consider NUA. The strategy is most beneficial if you hold highly appreciated shares. For example, if you purchased stock at $10/share and the current price is $100/share, this would be considered highly appreciated stock or shares with a low-cost basis. It is often not as favorable to declare NUA on employer stock that has not greatly appreciated above the purchase price.

It is important to also consider your estimated future tax brackets and the impact that may have when you sell the employer stock. If you have highly appreciated employer stock in your 401(k), let’s discuss when you would be able to declare NUA.

When are you eligible to take advantage of NUA?

NUA is only available to those who have a qualifying event.¹ Below are a list of events that would make you eligible:

• After the participant reaches age 59½

• Once an employee separates from service after age 55

• Because of the participant’s death

• After a participant becomes permanently disabled

If you meet one of the qualifications above, it is important to consider that electing NUA will require an entire distribution of the 401(k) plan. The NUA shares will be rolled over to a non-qualified taxable account, and anything not taken as NUA can be moved to an Individual Retirement Account (IRA). Upon declaring NUA, you must remove all the assets in the plan and there must be nothing left in the 401(k) at the end of the calendar year.

Tax Rates – Ordinary Income vs. Long-Term Capital Gains

Earlier, we talked about which assets are subject to ordinary income or capital gains rates, but why does this matter? Ordinary income is taxed based on the marginal tax bracket schedule. Generally, these rates are higher than long-term capital gains rates, even climbing as high as 37% for top earners. In contrast, long-term capital gains rates are generally lower than ordinary income rates, with the top rate at 20%. For capital gains to be considered long-term, the asset must be held for longer than one year.

How does it work? What taxes are due?

Upon electing NUA, the first step is the entire Lump Sum distribution from the 401(k). This means that the entire account must be distributed from the employer plan. The employer stock will be transferred to an individual account where taxes will be due on the cost basis. The transfer must occur in-kind, meaning that the shares must transfer as shares, not liquidated, and transferred as cash.

Non-NUA Assets Transferred to IRA

• Initial distribution: no taxes are due when transferring from 401(k) to IRA

• When stock is sold: when the stock is sold and withdrawn from the IRA, it is taxed as ordinary income

NUA Shares

• Initial distribution: taxes are due on the cost basis after the initial transfer, taxed as ordinary income

• When stock is sold: the difference between the stock price on the date of distribution and the cost basis is the “NUA Gain.” The NUA Gain is taxed at long term capital gains rates. Any gain above the NUA Gain is either a short or long-term capital gain depending on the holding period from the date of distribution

What are the Pros and Cons of NUA?

There are many considerations to electing NUA. A few of the advantages and disadvantages include:

Advantages

1. No Required Minimum Distributions: When the NUA stock is transferred to a brokerage account, the stock will not be subject to RMDs. However, the non-NUA assets transferred to an IRA are still subject to RMDs.

2. Favorable capital gains tax treatment: Any appreciation after declaring NUA will be taxed at either short or long-term capital gains rates. If the stock is held for longer than one year from distribution, the gain will be treated as long-term.

3. Flexibility to use funds when needed: After the transfer to a brokerage account, there are not time limits for when you can access the money without being subject to a 10% penalty (like attaining age 59 ½ for IRAs).

Disadvantages

1. Only applies to Employer Stock: This strategy only applies if you’re invested in employer stock and does not apply to the other investment options in the 401(k), like mutual funds or target date funds.

2. Concentrated stock position and lack of diversification: Having a large concentration of one stock can be risky and a diversified portfolio can help mitigate risk and volatility.

3. Taxes are due each year on dividends: Unlike an IRA, when stock is held in a brokerage account, taxes will be due on the dividends received.

Conclusion. Does NUA make sense for you?

NUA is a complex tax planning strategy that may lead to favorable tax treatment. There are many assumptions and variables that need to be considered when deciding whether to declare NUA on your employer stock. If you’re interested in learning more about NUA and determining if it would be advantageous for you, consult your tax professional and financial planning team to discuss your options.

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