If you own a concentrated stock position within your employer-sponsored retirement account, there’s a little-known piece of U.S. tax code that could save you a significant sum of money via net unrealized appreciation (NUA). However, NUA only applies to a select set of people; here’s what you need to know.
Who can benefit from NUA?
If you were paid company shares, including restricted stock units (RSUs) into an employer-sponsored 401(k), you may qualify for NUA. Timing can be key here; the IRS requires a triggering event—you’re retiring, you’ve quit working for the employer, you’ve reached 59½, or similar.
Additionally, you must take a lump sum payout (or rollover) of the entire amount in your 401(k) in the same calendar year you file the NUA paperwork.
Why would you want to leverage NUA?
Generally speaking, when you buy shares of a stock, you create a cost basis at the purchase price. In other words, any potential capital gains or losses are measured against a baseline: What you paid for the shares.
If you’re awarded shares by a company, the same rules apply—you create a cost basis at the market value of those shares when they were awarded to you.
Here’s where it gets a bit more complex. If you were awarded those shares in a taxable investment account, you’d owe income tax on the principal amount, but any future gains would count as capital gains (assuming you held the shares for longer than a year). The capital gains rate is nearly always lower than the income tax rate.
If you were awarded the shares in an employer-sponsored retirement account, you wouldn’t pay any income tax on the shares when they vested, and any gains would accrue tax free. However, you would pay income tax on both the principal and any potential gains when you withdraw the money in retirement. In other words, you could end up paying more tax on any potential gains by keeping those shares in a retirement account than in a taxable account.
That’s where NUA comes in. The IRS rule says you can roll those company shares out of your 401(k) into a taxable brokerage account retroactively, saving you the difference between the higher income-tax rate and the capital gains tax rate on any returns.
An example of how NUA works
Let’s say your employer grants you $50,000 worth of stock. When you retire, it’s worth $250,000. If your marginal tax rate is 28% in retirement, you’d pay 28% income tax on the entire $250,000 if you did nothing.
If you took advantage of NUA and rolled those shares into a brokerage account, you’d pay 28% income tax rate on the $50,000 when you roll the funds over. However, you’d pay a much lower capital gains tax rate on the remaining $200,000 when you sell those shares and realize the gains. Any new gains after you roll the shares over would need to be held for a year to qualify for long-term capital gains treatment.
This favorable treatment only applies to the company shares in your 401(k). Any other investments in your 401(k) funds must be rolled into a qualified account (like an IRA) to avoid taxes. If you were to distribute them to the regular brokerage account, they would be subject to the same taxation rules as any other 401(k) distribution.
If you took this NUA distribution before the age of 59½, the company shares may be subject to an early-distribution penalty of 10% on the stock’s original cost basis.
As you might expect from the many moving pieces discussed in this article, NUAs tend to be complex and it’s best to work with a professional to ensure the paperwork is handled correctly to avoid any potential issues. At Quorum Private Wealth, we work with our clients and their CPAs, tax attorneys, and additional providers to ensure each part of the process is handled by a qualified expert.
