Understand net unrealized appreciation for your 401K

Do know how NUA can help you

If you withdraw employer stock from a qualified retirement plan and receive the stock in kind (rather than rolling it into an IRA), you will pay ordinary income tax only on the original cost basis. You will not be subject to required minimum distributions, and when you subsequently sell the employer stock, you will only pay capital gain on the appreciation, as opposed to ordinary income tax.

For example, suppose employer stock in a 401(k) has a cost basis of $5,000, and a fair market value of $100,000. If the employee takes a lump sum distribution from the 401(k) and transfers the employer stock into a brokerage account, this is what happens:

• Ordinary income tax is immediately due on $5,000 and,
• When the employee subsequently sells the employer stock, the remaining $95,000 (referred to as the net unrealized appreciation, or NUA) is subject to long term capital gain tax, as opposed to ordinary income tax. Any change in the value of the employer stock after the distribution in kind will be treated as short or long term gain or loss, depending on when the stock is sold.

Do put NUA on your radar screen

Every individual who has employer stock in a qualified plan needs to be aware of the potential tax savings associated with NUA treatment. Once employer stock is rolled into an IRA, any NUA tax savings are lost, forever.

Do know the definition of a qualifying lump sum distribution tor NUA purposes

Generally, you can only take advantage of NUA treatment if you receive employer stock as part of a lump-sum distribution. For NUA purposes, to qualify as a lump-sum distribution, the following three (3) requirements must be met:

1. A “triggering event” must occur. Generally, a triggering event occurs when an employee dies, attains the age of 59 1/2, separates from service, or (if self-employed) becoming disabled.
2. It must be a distribution of the entire balance, within a single tax year, from all of the employer’s qualified plans of the same type (i.e., all pension plans, all profit sharing plans, or all stock bonus plans).
3. The company stock must be distributed as actual shares. The stock cannot be converted to cash before distribution.

There is only one exception: employer securities purchased with after-tax contributions will be eligible for NUA treatment, even if a distribution doesn’t qualify as a lump-sum distribution.

Do keep track of the cost basis of the employer stock

Employers are notorious for not being able, or refusing, to provide the cost basis for employer stock held in a qualified plan. If you take a lump-sum distribution, the cost basis is needed for NUA calculation, so you should keep your own cost basis records.

Do remember that NUA isn’t for everyone

There are also disadvantages to NUA treatment:

• The rollover IRA tax-deferred growth benefit is lost.
• Holding a significant amount of post-distribution employer stock may not be appropriate. The need to diversify or liquidate the stock for cash flow purposes will trigger capital gain tax, unless combined with another estate planning vehicle, such as a charitable remainder trust.
• Stock held in an IRA or employer plan is entitled to significant protection from creditors. That protection is lost if the employer stock is distributed in kind to take advantage of NUA treatment.

In certain cases, it might be best to roll the employer stock into an IRA.

Do talk with your advisors

In general, NUA treatment is appropriate for individuals who own highly appreciated employer stock in a qualified plan. However, whether it is appropriate in a given situation will depend on a number of variables, including a person’s age, creditor protection needs, timeframe for diversifying or liquidating the employer stock, estate planning goals, etc. Before deciding whether to take advantage of NUA treatment, be sure to speak with, and get a recommendation from, your financial advisor, accountant, and estate planning attorney.

Do not fall prey to the typical script

The script is typically the same: “When you take a lump-sum distribution from a 401(k), ESOP, or other qualified retirement plan, you should roll everything, including any employer stock, into an IRA.” Rarely is there any mention of NUA treatment. Don’t follow that script. Write your own, taking the possible tax savings into account.

Do not bother to try and get NUA treatment after an IRA rollover

Every year, taxpayers seek private letter rulings from the IRS, asking for permission to take employer stock out of a rollover IRA, so they can take advantage of NUA treatment. The answer from the IRS is always the same – “No!” So, don’t bother trying.

Do not mingle your post-distribution retirement stock with your other non-qualified investments

A number of financial advisors recommend keeping post-distribution employer stock in its own account. Once the stock is mingled with other other non-qualified investments, tax calculations can be burdensome.

Do not be surprised if you have to pay a 10% penalty

Even with NUA treatment, a 10% penalty may apply if you take a lump-sum distribution under the age of 59 1/2, unless you qualify for an exemption under Internal Revenue Code Section 72(t) (e.g. qualified domestic orders, unemployed individuals for health insurance premiums, first home purchase, or called to active duty).

Do not forget that NUA treatment is for beneficiaries and heirs too

If you die with employer stock in your 401(k), ESOP, or other qualified plan, your plan beneficiary(ies) can also use the NUA tax strategy. If NUA tax treatment is elected, however, the beneficiaries will not get a step-up in basis for the employer stock, despite the fact they receive the stock as a result of your death.

If you die after you’ve received the distribution of the employer stock, and elected NUA tax treatment, your heirs will have to pay long-term capital gain tax on the NUA (i.e., the difference between the cost basis of the employer stock and the fair market value of the stock on the original date of distribution). However, all appreciation as of the date of your death in excess of NUA will forever escape taxation, because the stock will get a step-up in basis.