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How to make the most of company stock in your 401(k)

It is not uncommon for employees to hold company stock in their workplace retirement plan. If you are one of those people, you will eventually have to decide how to distribute those assets – typically when you change employers or retire. Taking a distribution could leave you facing a big tax bill, but there is a tax break that you could take advantage of and could potentially help your situation called net unrealized appreciation (NUA).

When you have appreciated company stock you will have to pay taxes one of two ways – ordinary income tax or capital gains tax. With net unrealized appreciation you can pay the lower capital gains rate on a portion of your assets instead of the typically higher ordinary income rates when the assets are withdrawn from the tax-deferred account.  

What is Net Unrealized Appreciation?

NUA is the difference between the price you initially paid for a stock (cost basis) and its current market value. Say you could buy company stock in your plan for $10 per share. Five years later, that same stock is worth $30 per share. The difference between the current value of the stock and your cost basis is NUA.

You may be asking yourself, why does this matter? Well, as previously mentioned, when you distribute company stock there you can do it more tax efficiently with the IRS rules governing NUA. Instead of rolling the full amount of the 401(k) into an IRA or another 401(k), you can transfer the company stock into a taxable account and, in most circumstances, obtain preferable tax treatment.

Most times when you transfer assets from a 401(k) to a taxable account, you pay income tax on the market value. But, with company stock, you pay income tax only on the stock’s cost basis and not on the gain.

When you sell your company stock from your taxable account you will pay long-term capital gains tax on the stock’s NUA. The maximum federal capital gains tax rate is currently 20% which is far lower than the current 37% top income tax rate providing great potential tax savings with the use of this strategy.

When to choose an NUA tax strategy

Consider the following factors as you decide whether to roll your assets into and IRA or transfer company stock separately into a taxable account:

  1. Tax rates. The larger the difference between ordinary income tax rates and long-term capital gains tax rate, the greater the potential tax savings.
  2. Absolute NUA. The larger the dollar value of the stock’s appreciation, the more the NUA rules can save you on taxes.
  3. Percentage of NUA. An NUA that is a higher percentage of total market value creates greater potential tax savings become more of the proceeds will be taxed at the lower rate.
  4. Time horizon to distribution. The longer you plan to keep your assets invested in an IRA or taxable account before liquidating them, the greater the potential benefit of tax-deferred growth, and therefore, the less you would benefit from NUA. A shorter time horizon makes the NUA election more attractive.

Is NUA right for me?

Generally, it makes sense to utilize NUA when you believe your current tax rate is the same or lower than you expect it to be in the future. Consider the following conditions which may indicate your income will not fall sharply in the future:

  1. Are you retired?
  2. Are you taking RMDs too soon?
  3. Will you begin claiming Social Security benefits?

If you answer yes to all three, an NUA strategy may be to your advantage, although it is no guarantee. You should always consult with your tax or financial planning professional regarding your individual situation before making any decisions.