Lost your job or thinking about working for another company? Here are some ways that you can save on taxes when rolling over your 401(k) plan.
Do you own shares of your former or soon-to-be former employer in a 401(k) plan, Employee Stock Ownership Plan (ESOP), or profit sharing plan?
If you do, you can use Net Unrealized Appreciation (NUA) to pay capital gains taxes on your company shares instead of the higher ordinary income tax on distributions from a retirement account. In case you have never heard of NUA, it is an election under the US Tax Code to distribute appreciated employer stock out of an employer retirement plan.
Retirement Plan Options When Leaving Job
When you own company stock in a retirement plan and separate from the employer, you have two options for your retirement plan. The first option is to roll the entire retirement plan into an IRA. With this scenario you do not use NUA and if all assets in the retirement plan are pre-tax assets, future account distributions incur ordinary income tax.
The second option is to use NUA. If you have company stock inside the retirement plan, you can use this choice to take advantage of long term capital gains rates, which are lower than the ordinary income rates. There are several requirements for net unrealized appreciation.
NUA Requirements
The first requirement is an in-kind distribution. This occurs when the shares move from the retirement account to your brokerage account and you create a taxable event based on the cost basis of the employer shares.
The second requirement is a lump sum distribution. This means that the entire account balance of the employer retirement plan must be distributed in a single tax year.
The final requirement is a trigger event. The triggering events are death, disability, separation from service, and reaching age 59 ½. If you’re reading this, you definitely haven’t experienced the first triggering event!
Two Different Options
For illustration, let’s assume that you have $100,000 (market value) of employer stock in your 401(k) plan with a cost basis of $20,000. The first option is to use a simple rollover, and move the $100,000 from your 401(k) plan to an IRA. Provided these assets are pre-tax, all future distributions on the $100,000 and future growth from the IRA encounter ordinary income when distributed.
The second option is to use NUA for your 401(k) plan, and the $20,000 cost basis experiences ordinary income tax rates. The remaining $80,000 is taxed at long term capital gains rates.
The Value of NUA – A Tax Comparison of the Two Different Options
Confused? Let’s compare the tax implications for the two different scenarios, No NUA and NUA. The current market value of the employer stock is $100,000 with a cost basis of $20,000. The assumptions are:
Taxes
- 35% Ordinary Income Tax Rate
- 15% Long Term Capital Gains Rate
Values
- $100,000 market value of employer stock
- $20,000 cost basis of employer stock
Here is each scenario:
Scenario Comparison
| Market Value | Taxed as Ordinary Income | Taxed as Capital Gains | Ordinary Income Tax (35%) | Capital Gains Tax (15%) | Total Tax | |
|---|---|---|---|---|---|---|
| No NUA | $100,000 | $100,000 | $0 | $35,000 | $0 | $35,000 |
| NUA | $100,000 | $20,000 | $80,000 | $7,000 | $12,000 | $19,000 |
Under the No NUA scenario, the distribution is $100,000 and taxed at 35%, and the total tax due is $35,000.
With the NUA scenario, assuming that the employer stock is sold immediately at distribution and taxed at long term capital gains rates of 15%, the tax liability is $19,000.
In this illustration, NUA saves $16,000. This is a very straightforward example. Using net unrealized appreciation can be complex and it depends on your entire financial picture. Here are some considerations when an NUA strategy can be appropriate.
NUA for Highly Appreciated Stock
If you have company stock that has gone up substantially in value, NUA can be very advantageous. The larger the spread between the market value and the cost basis, the more favorable the net unrealized appreciation. A larger spread means a larger capital gain. Paying tax at 15% instead of 35% on this gain has tremendous tax savings!
Tax Spread
Tax brackets change based on levels of income for both ordinary income taxes and capital gains taxes. Long term capital gains rates become more beneficial as the spread between the two increases.
What Should You Do?
If you are interested in NUA, start by reading through the details in your employer 401(k) documents. Then, talk to an expert about the details of cost basis and market value to determine if NUA fits into your financial plan. Net unrealized appreciation can lower your tax liability and you will have more cash in your pocket. If you have questions about net unrealized appreciation, your 401(k) documentation, or anything else, you can set up a free consultation.