A Guide to Net Unrealized AppreciationSubmitted by Castlebar Asset Management on August 11th, 2016
Owning your company’s stock in your 401k is a common way to save for your retirement. When you leave your company you will probably just roll your 401k or other workplace plan into an IRA and not think twice about the process. If you do hold company stock in your 401k there is another option that may be a smarter financial move for you to look at with your financial planner or accountant.
A tax rule called net unrealized appreciation (NUA) allows you to take any company shares you hold and separate them from the rest of your 401k when you do your rollover. Your company shares would be transferred to an after tax investment account and your other 401k balance would be rolled into an IRA. The NUA is the difference between the current market value and the price you paid for your company stock. You will have to pay income taxes on your company stock cost basis and then capital gains on any profits when you sell. The reason to consider this strategy is if you are looking for a tax optimized way to access these funds in the short term. Using NUA could save you a substantial amount of money.
There are specific criteria that you must meet to qualify to use NUA. You have to distribute your entire balance of your plan in one tax year. This does not need to happen at one time but does have to happen in one year. Your company shares have to be distributed as actual shares. You are not able to sell them first and then distribute the cash. Finally, you have to experience the following events:
- Separate from the company (voluntary or you were let go), except for self-employed workers,
- Reach the age of 59.5,
- You become totally disabled (for self-employer workers only), or
NUA is most attractive to those stocks who have a low costs basis, a shorter time horizon and are in a higher tax brackets. Let’s walk through a few examples.
Jane is a 60 years old, is in the 39.6% income tax bracket and her capital gains rate is 20% plus the 3.8% Medicare surplus tax. Jane’s cost basis is $35,000 and the current market value is $150,000 for her company stock. She plans to sell her shares immediately. By selecting the NUA option she will have $18,170 more than rolling it over and taking a distribution after taxes. Jane will pay $13,860 on her cost basis and then $27,370 in capital gains taxes. If Jane had selected the rollover option her tax bill would be $59,400.
Paul is a 50-year-old who falls into the 39.6% income tax bracket and has a capital gains rate of 20% plus the 3.8% Medicare surplus. Paul’s cost basis is $25,000 and the market value of his company shares are $125,000. He wants to sell his stock immediately. Paul will have to pay a total of $12,400 in taxes on his cost basis. This $9,900 at his income tax rate plus the penalty of 10% because he is not 59.5. His capital gains would be $23,800 and his ending value would be $88,800. If Paul wanted to look at the IRA option he would pay $62,000 in taxes between his income taxes and penalty. The NUA option will give him over a $25,000 benefit.
Beth is a 40-year-old who falls in the 28% tax bracket and has a long term capital gains rate of 15%. She is subject to an early withdrawal penalty of 10% from her rollover IRA. Beth has $40,000 in company stock with a cost basis of $35,000. Taking the NUA option would require Beth to pay income taxes and a penalty of $13,300 and then capital gains of $750. If Beth opted to rollover her 401k and then take a distribution she would pay taxes and penalty of $15,200. The NUA route would give her $1,150 more verses the rollover strategy.
NUA makes the most sense if you have a short time horizon. The tax deferred benefits of an IRA will give you more value in the long term. If you have a cost basis close to the market value of your company stock holdings then it usually makes more sense to roll your shares into an IRA. Finally if you are in a low tax bracket NUA may not be the right path to take. Before using a NUA strategy work with your tax professional or financial planner to make sure you qualify and the numbers add up.
Disclaimer: The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your personal financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results.