Net Unrealized Appreciation

Net Unrealized Appreciation

Diversification is touted by many in the investment and financial planning community because it spreads your risk over multiple stocks and/or assets classes.  For those individuals who have not heeded the advice of the investment and planning community over the years by investing directly and heavily in your company stock through your 401(k) plan, there is a very narrow and beneficial tax loophole that you can jump through.  But be very careful when jumping and be sure to review the transaction after it is completed to make sure that it was successfully executed, though once set in motion it is extremely difficult if not impossible to unwind.  If done correctly, it can be a very nice benefit – especially with tax rates likely to rise in the future – but if done incorrectly it can cost you dearly. 

The strategy is referred to as NUA – Net Unrealized Appreciation – and it relates to JUST the company stock in a 401(k).  Let’s take a look at a quick example to better understand. 

After working with your employer for many years, you end up with a $500,000 401(k) account.  Of this, $250,000 is in company stock and $250,000 is in various mutual funds that the 401(k) had as part of the plan offerings. 

Let’s further assume that your direct investment – or cost basis - in company stock was just $50,000 and the rest of the value was in ‘unrealized appreciation’ – or simply the appreciation in the stock over what you paid for it. 

The NUA strategy allows you to distribute the stock from the account and pay ordinary income taxes on JUST your cost basis (in this case the $50,000) and the appreciation gets to come out tax-free, for now.  Upon selling the stock in the future, you will pay long-term capital gains rates on the unrealized appreciation rather than ordinary income tax rates. 

It sounds like a pretty good deal, right?  It is and can be very beneficial especially if you intend to hold the position for some time AND the difference between the cost basis and the current value of the company stock is wide enough. 

There are a couple of rules to acknowledge:

1)   In order to do a NUA correctly, the entire 401(k) account balance must be empty at the end of the calendar year.  This means that you must roll over the non-company stock to an IRA and make sure that all shares of the company stock get transferred to either a brokerage account or IRA.  

It also means that it is advisable NOT to do this in November or December as it is too close to the end of the year to make sure that it all gets done correctly. 

2)   If you are under age 55 when you leave the company, you will also have to pay a 10% penalty on the BASIS in addition to the ordinary income tax. 

3)   NUA can only be done while the company stock is in the 401(k).  It can’t be done after you have already rolled the account balance to an IRA. 

4)   If you have retired from the company and taken a distribution prior to doing the NUA/rollover strategy, then you need to talk with your accountant and/or financial planner.  Previous distributions may jeopardize your eligibility to elect NUA unless you have had a qualifying event. 

As with any strategy, there are also a couple rules of the road to know about before implementing it. 

a.    The lower the basis relative to the total value of the stock the better the strategy is – in essence because you are reducing the amount that is subject to ordinary income tax rates.

b.    You can ask the 401(k) provider for a breakdown of your share purchases, as long as they kept detailed records.  This could allow you to simply identify the positions with the lowest basis and use those to implement the NUA strategy while letting the rest of the shares transfer to your IRA. 

c.    You need to expect your ordinary income to be higher than capital gains rates in the future.  This may seem like a no brainer but there are many retirees that will enter an extremely low period of tax brackets during their 60s before forced distributions out of the IRA begin at age 70.5. 

d.   The 401(k) provider will issue you several 1099s to document the rollover IRA.  They will indicate on Box 6 how much of the distribution of company stock was net unrealized appreciation versus how much was employee contributions.  You should review this to make sure that it matches your records from the rollover conference call. 

As with any complex strategy, proper execution is critical.  This starts with the initial phone call to the 401(k) provider to make sure that it is eligible for you and continues all the way to properly reporting it on your tax return.  If you are not familiar with the process, then I recommend working with your qualified professionals every step of the way to make sure that you don’t jeopardize the benefits of the strategy.