This widely misunderstood section of the IRS code can be quite a benefit – if it happens to fit your situation. Net Unrealized Appreciation (NUA) refers to the increase in value of your company’s stock held within your 401(k), either due to a company match or your own investment in the company stock within the 401(k). Other company-sponsored deferred accounts can apply here as well, but the primary type of account is the 401(k), so we’ll refer to all company-sponsored tax-deferred accounts as 401(k)’s for the purpose of this discussion.
In order to take advantage of the Net Unrealized Appreciation provision, first of all you must hold your company’s stock in your 401(k), and you must be in a position to roll over the account. That is, either you must have separated from service by leaving employment (voluntarily or involuntarily), or the 401(k) plan is being terminated.
As you consider the rollover of your funds, if the company stock has increased in value, you have net unrealized appreciation. That is, there is a net increase or appreciation in value that has not yet been realized by sale of the stock. The IRS allows for this net unrealized appreciation to be treated as a capital gain, which can result in much lower tax rates on the gain versus ordinary income tax rates.
In order to take advantage of this special NUA treatment, the 401(k) account must be completely rolled over in one tax year. There is one thing that you must do differently from other rollovers, however: The company stock will be rolled over into a taxable (non-IRA) account, while everything else will be rolled over into a traditional IRA.
When you rollover the company stock, this will be considered a distribution. As with any distribution, you will be required to pay the tax on the basis (or cost) of the stock as well as the 10% penalty if you were under age 55 when you left the employer. Your employer or plan administrator will have records on your basis of the stock.
As an example, let’s say Frank has participated in the company’s 401(k) plan for several years and he’s now ready to retire. Part of the 401(k) funds were invested over the years in Frank’s company’s stock, which has cost Frank a total of $10,000 through the years (this is the basis). Frank’s company has done well, and now the stock is worth $150,000 in the market. If Frank rolled over the company stock into an IRA, when he withdraws the money he would pay ordinary income tax on that growth of $140,000 – at whatever his current marginal income tax rate at that time. Instead of going that route, Frank decides to use the NUA provision in the tax law – much to his advantage.
So, Frank sets up an IRA and a taxable account at the custodian of his choice, and he directs the 401(k) administrator to roll over his company stock to the taxable account, and all other funds to the IRA. When Frank rolls over the company stock into the taxable account, he will be taxed at ordinary income tax rates (plus the 10% penalty if he was under age 55) on the basis of the stock – which is $10,000. Now, not only will the growth of the stock ($140,000) have a tax rate of 15% or less as capital gains, Frank also will not have to take required minimum distributions (RMD) from those funds upon reaching age 70½ . Frank can leave the company stock in that taxable account forever if he wishes, and then hand it over to his heirs. (Note: NUA stock doesn’t receive a step-up in basis like other appreciated stock.)
Here’s the math: Frank pays tax at an example rate of 25% on the $10,000 basis of the stock, or $2,500. Frank is over age 55, so no 10% penalty applies. Then, as he sells the stock, the total amount of capital gains tax would be 15% at today’s rates of $140,000 (just the growth!) or a total of $21,000. Compare that to the non-NUA treatment, where Frank would be taxed with ordinary income tax rates on the entire $150,000 stock value over time, for a total of $37,500! In this example, Frank has saved a total of $14,000 in taxes! Wow…
Now, NUA treatment doesn’t work for all situations. For example, if your company stock has only grown minimally in value, or has gone down in value, there is little or no benefit to utilizing the NUA option. Also, if the basis of the stock is fairly high relative to the growth, it might make sense to only apply NUA treatment to a portion of your company stock, which is also allowed. One last thing – this NUA treatment only applies to the stock of your employer. No other stock can receive this treatment.