NUA—What You Need To Know

39338076_sJeff is away and so he asked me to write the article this week. At first I was hesitant. As I told him, he has very big shoes to fill. But then I decided it might be fun to teach you all about something very few people are aware of, a little-known tax break available for net unrealized appreciation, or NUA. (I’m sure many of you can’t imagine this topic being “fun” for anyone!)
Let me begin by giving you the definition of NUA. Net unrealized appreciation is the difference in value between the average cost basis of company stock held in a 401(k) and the market value of that stock if and when it is transferred out of that 401(k).
You may wonder why it is important to be familiar with this term. Well, those of us lucky enough to have an employer-sponsored retirement plan know that oftentimes there are limited choices of investments in those plans. Sometimes, however, those choices include company stock. The theory behind offering company stock as an investment option in a 401(k) is that if employees are “invested” in the company, they may be more compelled to work hard.
But even those who own company stock in their 401(k) eventually move on. And most of you know that, typically, people can move their funds out of company-sponsored retirement plans when they either retire or switch employers. This is usually accomplished by moving them directly from the custodian of their former workplace plan to the custodian of either another employer-sponsored retirement plan or an IRA. When this is done, it is considered a direct transfer that does not result in any taxes being imposed.
Alternatively, funds can move from a company-sponsored retirement plan to a new employer’s plan or to an IRA through the issuance of a check to the former employee. The check is then deposited into another tax-deferred retirement account. When it is done this way, it is considered a rollover. With a rollover, you only have 60 days to deposit the funds into a new plan or IRA, otherwise the transaction is considered a distribution, rather than a rollover, and the entire distribution is taxable (it is also usually subject to a 10 percent penalty for those under age 59 1/2).
Taxpayers are limited to one rollover in any 12-month period, no matter how many IRAs or retirement annuities they own. Therefore, a direct transfer is usually preferable, as there is less of a chance of suffering an unintended tax consequence. Most people refer to both methods as a “rollover” and so that is what I am going to do for purposes of this article.
When our clients are looking at retirement, they often decide that they want to roll over their 401(k) to an IRA so they have more investment options that they cannot get with their 401(k). Most automatically assume that the entire account should be rolled over, understandably. This way, they can continue to get tax-deferred growth on their investments. And although this is usually the way to go, there are exceptions.
One of those exceptions can apply when there is NUA. If company stock with NUA is rolled into another tax-deferred retirement account, whether that stock is sold and the funds are distributed right away, or held for years as it appreciates and then sold, does not matter for tax purposes. The entire amount of any distribution resulting from the sale of that stock (or any other IRA investment) is taxed as ordinary income.
So, you may ask, other than roll it over, what else can you do with company stock that has net unrealized appreciation? Well, if you transfer that stock to a regular brokerage account, you can avoid ordinary income tax on the NUA. Rather, upon the transfer, only the cost basis in the stock is treated as a taxable distribution, subject to ordinary income tax. The NUA is taxed at long-term capital gains rates when it is sold, even if it is sold the very next day after it is transferred to a nonqualified brokerage account. (Any increase in value earned after it is transferred to such a brokerage account will be taxed at ordinary income tax rates if it is sold within one year, otherwise that additional growth is also taxed at long-term capital gains rates.)
By choosing to transfer appreciated company stock to a brokerage account, rather than an IRA, from a 401(k), the total tax liability can be substantially lower than it would be if rolled into an IRA. Again, this is because net unrealized appreciation is all taxed at long-term capital gains rates, rather than ordinary income tax rates.
But as Jeff often says, there are pros and cons to everything. Moving the appreciated company stock to a brokerage account will result in what could be a substantial tax bill the year it is transferred. Remember that the cost basis of that stock will be taxed upon the “distribution” to the brokerage account at ordinary income tax rates and if the stock is sold that same year, the NUA will be subject to tax in the same year, but at capital gains tax rates.
On the other hand, if the appreciated company stock is rolled into an IRA, although it will all eventually be taxed at ordinary income tax rates, it will only be taxed when distributions from the IRA are taken.
There is one other possible benefit of transferring appreciated company stock out of a 401(k) to a brokerage account: by doing so, going forward the value of that stock is no longer included in the calculation of RMDs.
Keep in mind, as with most tax-related rules, there are strict criteria that must be met in order to qualify for the favorable treatment, one of which is that you must distribute your entire vested balance in your plan within one tax year. Therefore, it is very important to seek guidance from a knowledgeable professional before you make any decisions related to NUA.
I know Jeff always ends with the advice to “be vigilant and stay alert because you deserve more,” but I am going to suggest something else: proceed with caution, but always move forward.
This has been fun—maybe I’ll do it again soon. Have a great week.
1. http://tinyurl.com/28o82ar; 2. http://tinyurl.com/qesjvwr; 3. http://tinyurl.com/qb3ygae