If you own company stock in a retirement account, there’s a little-known tax strategy that could save you a substantial amount when you take distributions. It’s called net unrealized appreciation, also known as an NUA.
NUA lets you shift part of your tax liability from higher ordinary income tax rates to lower long-term capital gains rates. For many retirees and employees with appreciated company stock, this can mean thousands in tax savings, leading to better wealth management.
Here’s what you need to know about how an NUA works and when you should consider it.
WHAT IS NET UNREALIZED APPRECIATION (NUA)?
Net unrealized appreciation (NUA) is the difference between:
- The stock’s original purchase price (your cost basis)
- The stock’s market value when it’s distributed from your retirement account
This only applies to employer stock you’ve accumulated in a qualified retirement plan, like a 401(k). These shares are often received through matching contributions, bonuses, or employee stock purchase plans, so their cost basis is typically lower than their current market value.
HOW NUA CAN HELP LOWER TAXES
Normally, when you take money out of a traditional retirement account, whether it’s in stocks, bonds, or mutual funds, the entire withdrawal is taxed as ordinary income, even if the growth came from long-term capital gains.
That could mean paying up to 37% in federal taxes, plus any applicable state taxes.
With an NUA strategy, you separate the company stock from the rest of your retirement funds. Here’s the tax advantage:
- You pay ordinary income tax only on the original cost basis of the stock.
- The growth (the NUA) is taxed later at the standard long-term capital gains rate, which caps out at 20%.
This tax treatment can dramatically reduce what you owe when you sell.
EXAMPLE OF NUA TAX BENEFITS
Let’s say you have 5,000 shares of company stock in your 401(k). The original cost per share was $4, but the current value per share is $20. Since you were granted 5,000 shares at $4 each, the cost basis is equal to $20,000. However, since the current value per share is $100,000, your NUA is $80,000 – the difference between the cost basis and the current value.
If you sell these shares without using an NUA strategy, you would pay ordinary income tax on the full $100,000. But with an NUA strategy, you only pay ordinary income tax on just $20,000 now. The $80,000 gain is taxed at the lower capital gains rate when you eventually sell the stock.
HOW IS NUA TAXED?
When you take a qualifying lump-sum distribution, the IRS uses a split-taxation method:
- Cost basis: The original amount is taxed as ordinary income within the year of the distribution.
- NUA (the appreciation): The difference between the cost basis and the growth is taxed at long-term capital gains rates after you sell the stock.
For example, let’s say you have company stock that is currently worth $300,000. The original shares were purchased for $80,000 – this is the cost basis. Over time, these shares have grown $220,000.
Under the NUA rules, you’ll pay ordinary income tax on $80,000 now, and the $220,000 will be taxed as long-term capital gains when you sell.
NUA DISTRIBUTION RULES
Not every retirement plan participant qualifies for this strategy. To use NUA tax treatment, you must meet certain requirements.
- Triggering Events: You are eligible for NUA tax treatment in any of the following situations:
- Separation from service (leaving the company)
- Reaching age 59½
- Total disability (self-employed individuals only)
- Death (NUA is passed to beneficiaries)
- Lump-sum distribution: The entire balance of all accounts of the same type (for example, all 401(k)s with that employer) must be distributed within one calendar year.
YOUR DISTRIBUTION OPTIONS
When you’re ready to take your distribution, you have three main options for your company stock:
- Take the stock directly: Receive some or all company shares outright. You’ll pay ordinary income tax on the cost basis now. Unfortunately, you will not reap any future price appreciation in the stock.
- Roll it into an IRA: Keeps the money growing tax-deferred, but you would forfeit the NUA benefit, meaning that future withdrawals would be taxed at an ordinary income rate.
- Transfer it to a taxable brokerage account: This fully preserves the NUA benefits. Only the cost basis is taxed at distribution, and future gains are taxed at favorable long-term capital gains rates.
WHEN AN NUA STRATEGY MAKES SENSE
How can you determine when an NUA is the best option, and when to simply roll your stock into an IRA? An NUA works best when certain factors align:
- The company stock has grown significantly: The bigger the gap between the cost basis and current value, the greater the potential tax savings.
- You hold a large percentage of company stock in your retirement plan. This is because a larger amount of the growth will be subject to a lower capital gains tax rate, rather than higher ordinary income tax rates.
- You’re in a high tax bracket: The difference between ordinary income tax (up to 37%) and capital gains tax (20% max) creates significant savings.
- You need cash now: Taking the stock directly and selling some of it can provide liquidity while still taking advantage of the NUA rules.
THE BOTTOM LINE
An NUA tax management strategy can be a powerful way to reduce taxes on highly appreciated company stock. You could save thousands when you sell by shifting part of your distribution from ordinary income rates to lower capital gains rates – this is something to consider when retirement planning.
However, the rules for an NUA strategy are complex, and a wrong move can cost you. Work with a CFA advisor, CPA professional, or remote advisor to make sure this strategy fits your overall retirement and tax plan.
Disclaimer: This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk. Content in this material is for general information only and is not intended to provide specific advice or recommendations for any individual. All investing involves risk, including loss of principal. No strategy ensures success or protects against loss.