When leaving a job, it is a common practice to roll your 401(k) account into an IRA. This can provide a vehicle to preserve the tax-deferred nature of this money and can provide a wide range of investment options for you to consider.
In the event your 401(k) account contains shares of company stock, utilizing the net unrealized appreciation (NUA) rules when leaving the company can be a smart move that could potentially result in significant tax savings.
What Is NUA?
Net unrealized appreciation refers to gains on company stock held in your 401(k) plan. Although NUA can also apply to other qualified plans, the 401(k) is the most common version, so this will be the one referred to here.
The increase applies to stock purchased with your own salary-deferral contributions or via an employer match.
How Does It Work?
Generally, when leaving a job and looking to roll your 401(k) over into an IRA, you would simply set things up to roll the entire account over to the new custodian to preserve the tax-deferred nature of the account.
When a distribution is taken from a traditional 401(k) account the entire amount of the distribution is subject to income taxes at ordinary income tax rates. The exception to this is the cost basis of any after-tax contributions made to the plan.
When you are leaving your company, voluntarily or otherwise, or if your company’s plan is terminated, you have the option of treating the company stock held in the plan differently. Under the NUA rules, you can take a distribution of the stock and pay income taxes on the cost basis of the shares. You would then roll the rest of the account balance into an IRA.
The distribution of the stock would be made to a taxable brokerage account, where you would hold the shares until they are sold at a later date.
A few things to know when considering the net unrealized appreciation treatment of company stock:
- This applies only to your employer’s stock held in the plan. If shares of another company’s stock are held in the plan, those shares would not be eligible for NUA treatment and should be rolled over to an IRA with other assets in the plan.
- To qualify for NUA treatment the entire 401(k) account must be rolled over within a single tax year.
- Income taxes are due on the cost basis of the company shares, and a 10% penalty would apply if you are younger than age 59½.
- The administrator of the 401(k) plan should have records of your cost basis in the company shares.
- You do not have to use NUA on all of the shares; you can choose to roll some of them over to an IRA along with the rest of the assets in the account.
- If the stock has a high cost basis, you might not want to take the NUA treatment on all shares because of the high dollar amount of the taxes that would be due.
The benefit of using net unrealized appreciation is the potential tax savings. For highly appreciated company stock held in your 401(k), paying tax at the preferential capital gains rate, rather than ordinary income tax rates, can result in significant tax savings. Also, once the NUA option is taken, the shares are immediately eligible for the preferential capital gains tax treatment instead of having to wait the normal one year and one day on a holding purchased in a taxable account.
The Potential Benefits of NUA: An Example
Let’s say your 401(k) plan holds $200,000 worth of company stock with a cost basis of $50,000.
When leaving your company, you pay income taxes on the $50,000 cost basis of the stock. If your income tax rate is 30% for this example, you would owe $15,000 in taxes.
If you sold the stock and realized a gain of $150,000 and paid taxes at the preferential 15% capital gains rate, your tax would be $22,500.
Your tax rates could of course vary, but even for those in higher income brackets, the savings by paying capital gains rates is significant. If the shares were rolled over to an IRA, the full market value would be taxed at the higher ordinary income tax rates when eventually distributed from the account.
A related benefit of going this route is that the value of the shares does not become subject to required minimum distributions when you reach age 70½.
The stock of course does not have to be sold right away or at all. However, if you die with the stock in your account, your heirs would not receive a step-up in cost basis as they would with other investments held in a taxable account.
For those who hold shares of their employer’s stock in their 401(k), they should be aware of the net unrealized appreciation option when leaving their company. In the right situation this option can result in very significant tax savings for them and is an excellent financial planning tool to keep in mind.