When Does Using Net Unrealized Appreciation Make Sense?

In many cases an NUA distribution can reduce taxes over the long haul

Woman evaluating company stock distribution options.
It is best to evaluate your stock distribution options before you roll everything over. Hero Images/Getty Images

If you have company stock in a retirement plan and want to roll it over to an IRA, most likely you will not be able to – although you may be able to distribute the stock out of the plan.

Why can’t you roll the stock over?

Most 401(k) plans send a check or wire the funds in cash directly to your chosen IRA account when you do a rollover. There are very few 401(k) plans that allow what is called an “in-kind” transfer/rollover where shares of the investments you own inside the 401(k) are transferred in-kind to your IRA.

 

In-kind transfers are not usually available because most of the time the investment choices inside a company retirement plan are not available outside the plan - for example many 401(k) plans offer a special class of mutual fund shares for retirement plans. And stable value funds, a common choice inside retirement plans, are not available outside the plans.

What can you do with your company stock when it is owned in a 401(k), ESOP, or other company plan?

When you retire or leave the company you have a few choices:

  • Distribute the stock from the plan under special tax rules
  • Rollover all funds in cash to an IRA (you can also distribute the stock under special tax rules and then rollover the remainder of the funds to an IRA)

Let’s look at how the special tax treatment on distributing the stock works to see if that makes sense for you.

Distribute the stock for “net unrealized appreciation” tax treatment

If the company stock in your retirement plan was purchased with employer contributions or with your own pre-tax contributions then it is eligible for net unrealized appreciation tax treatment.

It takes some calculating to determine if this special tax treatment will be beneficial for you.

To understand how it works, let’s walk through an example. Suppose you have $60,000 of WIDGET stock in your retirement plan.

Think of your company stock as composed of three parts:

Cost Basis – this is the price (or average price) paid for the shares.

Your employer can provide you with this number. For our example, we’ll assume the cost basis of the total shares you own is $25,000. When distributing the stock as a lump sum upon retirement you would pay tax at your ordinary income tax rate on the cost basis amount. So in the year of distribution $25,000 of income would be reported on your tax return as a pension distribution.

Net Unrealized Appreciation (NUA) – this is the difference between the cost basis and the market value when the stock is distributed from the plan. Assume the day the stock is distributed the total value of your shares is $60,000. As your cost basis is $25,000, the net unrealized appreciation would be $35,000. Normally you do not pay tax on this net unrealized gain until you sell the stock, and at that time it will be taxed at long term capital gains rate even if you sell it right away. (You can make a special election to pay the tax at the time of distribution – which might make sense if your income for the year put you in a low or zero percent capital gains rate and you expected in the future your capital gains tax rate would be much higher.)

Additional Appreciation – once you distribute the stock, if it continues to go up in price, this would be additional appreciation which is taxed as either short or long term capital gains rates depending on how long you hold the shares after they are distributed from the plan.

You have to hold the shares for a minimum of 12 months to qualify for the lower long term capital gains tax rates.  

How to determine if NUA tax treatment saves you money

There are several online net unrealized appreciation calculators, however I find most of them are flawed. Here are the problems with the online calculators I have seen:

You must input a single marginal tax rate. This is flawed as the year you take the distribution, if the basis is large enough the extra income may move you into a higher marginal tax rate for that year, whereas in future years it may be lower.

You must input a single capital gains tax rate. In reality your capital gains tax rate depends on your taxable income for the year. With proper tax planning many retirees can have several years where they may pay no tax on capital gains.

You must input a set holding period. The NUA calculators require you to input a holding period which is the expected number of years you would hold the stock after it was distributed from the plan. If you are in retirement you may be selling some stock each year, rather than holding it for a specific number of years.

A customized analysis will allow you to use a timeline format to input annual projected marginal tax rates, projected capital gains rates, and distributions on a year-by-year basis.

General factors to consider when determining which distribution option is best

Age – the younger you are the more time there is for the compounded growth of tax deferral in an IRA to outweigh the lower capital gains tax rates that may be in effect by distributing the stock. However all the normal 401(k) age distribution rules apply – NUA distributions are not exempt from early distribution penalty taxes.

Amount of funds in retirement accounts – if the majority of your funds are in tax-deferred accounts (401ks, IRAs, 457s, 403bs, etc.) then distributing stock with NUA tax treatment may give you the opportunity to quickly develop a greater balance between pre-tax and after-tax funds. This may result in additional tax savings later in your retirement years when required minimum distributions (RMDs) from retirement accounts begin. By lowering the amount of money in retirement accounts you will be lowering your RMDs.

Amount of NUA – if the basis is low and the current value of company stock is high, it may make the NUA tax treatment more favorable.

Your tax rates – If your ordinary income tax rate in future years when you will take distributions from retirement accounts is projected to be quite a bit higher than long term capital gains tax rates this may make the NUA strategy more favorable.

Risk – An individual stock is a far riskier investment than a diversified portfolio. If the company stock represents a large portion of your financial assets and you plan on holding the stock after distributing it from the plan you must consider the amount of investment risk this entails.

When considering these how to distribute company stock from a retirement plan a customized analysis by a qualified retirement planner or tax specialist is recommended.