If you own company stock in your 401(k) or other qualified plan, you will want to make sure to understand what Net Unrealized Appreciation (NUA) is and how making the wrong distribution decisions could potentially cost you thousands of dollars in additional taxes.
When one separates from work due to retirement, a rollover to an IRA is one of the more popular options exercised. The pre-tax dollars simply go to the IRA, and taxes are deferred until distributions are made. Upon distributions, these previously never taxed dollars are then taxed at the ordinary income tax rates of the taxpayer at time of distribution.
But what if one works for a publicly traded company and holds company stock inside of their retirement plan such as a 401(k)? There is a special rule, IRC 402(e)(4), that provides for preferential tax treatment of the NUA that allows for the gains that took place on the stock to receive a preferential capital gains tax treatment outside of the plan instead of being taxed as ordinary income.
Let’s assume Mary utilized her 401(K) contributions to purchase $100,000 of employer stock in her 401(k). Let’s also assume that at retirement the stock is worth $250,000. Finally, let’s assume that the rest of her portfolio consisting of other funds is worth another $750,000, or a total portfolio of $1,000,000. When Mary separates from work at retirement, she will have several options. Let’s take a look at 3 of them.
Option 1: Exercise the NUA Benefits
Mary would transfer in-kind the company shares to her brokerage account with a value of $250,000, and the remaining $750,000 would roll-over to her IRA. Of the $250,000 of company stock, the cost basis of $100,000 would be taxed at ordinary income tax, but the growth of $150,000 would be taxed at the more favorable capital gains tax upon disposal. If she decides not to dispose of the stock, she would still pay ordinary income tax on the $100,000 but the gains would continue to be deferred until disposition at which point it would receive capital gains treatment. Based on holding periods, it would be treated as either short-term or long-term capital gains.
Option 2: Roll-Over Everything to the IRA
Mary would transfer the entire $1,000,000 portfolio to her IRA. Upon distribution, she would be subject to ordinary income taxes, including on the gains of the company stock. The opportunity for NUA would be lost.
Option 3: Pick and Choose
Since Mary acquired the company stock over multiple dates, the cost basis of each lot of purchases will be different. Some stocks have a very low basis, while others have high basis. In this case, Mary would transfer in-kind the shares with the very low basis and rollover the ones with higher basis to her IRA.
IRA Rollover Danger
The standard advice of rolling over a lump sum distribution into an IRA to postpone immediate tax could prove to be an expensive mistake in certain situations since the capital gains rate benefit on the NUA would be lost. Thus, in many cases, employees may be better served by moving a lump sum distribution of appreciated employer stock into a taxable brokerage account.
Obviously, there is no single “right” solution. A direct distribution of employer stock may make the most sense where employer securities have greatly appreciated, and a taxpayer’s ordinary/long-term capital gains rate differential is greatest. Other factors to consider include cost basis and a potential 10% early-withdrawal penalty.
Steps to consider:
- Review your retirement statement and look for company stock and the associated cost basis. If the price has appreciated, consider the benefits of NUA.
- In order to qualify for NUA, the entire plan must make a “lump-sum distribution” in a single calendar year. This means one should start early in the year to allow for enough time to complete the transfers.
- If you are subject to Required Minimum Distribution (RMD), you can use the distribution of the employer stock to satisfy the requirement.