By Andy Ives
The bulging stock market, combined with a wave of employees leaving their jobs either through retirement or layoffs in the wake of the pandemic, has created a perfect storm of opportunity for tax planning with company stock in a 401(k). Additionally, many plan participants do not even realize their 401(k) account balances have grown exponentially. If ever there was a time for mastering the nuances of the net unrealized appreciation (NUA) tax break, it is now.
Unfortunately, when a sizable retirement plan rollover opportunity presents itself, there is a high potential for certain elements to be overlooked. As such, proceeding with a plan-to-IRA rollover without a full assessment of the situation could be disastrous. Haste makes waste. While most advisers understand the pros and cons of a rollover, there is one analysis that often goes unnoticed – NUA. Not considering NUA when discussing the benefits of a plan-to-IRA rollover is abject failure – an oversight that could even expose an adviser to liability. Before submitting any paperwork to a plan custodian requesting a rollover, one must understand the basic art and science of NUA.
What is the NUA tax break, i.e., the science? It is the opportunity to pay tax at long-term capital gains rates on the appreciation of company stock vs. paying ordinary income rates on that growth. While the tax savings can be significant, one misstep, one broken beaker in the science lab, and the NUA opportunity will be forever lost.
When NUA Is an Option
When a person owns company stock in her 401(k) plan, a possible NUA opportunity exists. This company stock can be held as individual shares or as a stock fund that is converted to shares upon distribution. No company stock, no NUA. If company stock appears on a client’s statement, the best bet is to work through a basic analysis to determine if NUA is, indeed, an option.
1. Is the Stock Highly Appreciated? Upon identification of the company stock, the next detail to pin down is the amount of appreciation. There is no magic percentage dictating what level of growth makes for a good NUA opportunity. “Highly appreciated” is subjective. Every client is different, and every client will have an NUA tipping point where it makes sense. Identifying that tipping point is the art of NUA. Based on the level of appreciation in the company stock, based on client needs and an understanding of tax bracket management, a decision can be made on how to proceed.
2. Trigger Event. If we decide to pursue NUA, we must determine eligibility. Not everyone can participate. There must be a qualifying “trigger” event, and there are only four such triggers:
- Reaching age 59½ (although the plan is not required to allow an in-service distribution at that age);
- Separation from service (not for the self-employed);
- Disability (only for the self-employed); and
To be eligible for NUA, one of these triggers must be met. Upon reaching the trigger criteria, a theoretical NUA light will turn on.
3. Is the Trigger Still Active? Simply because an NUA trigger light is turned on does not mean it will remain lit in perpetuity. Certain actions will “activate” the trigger light, causing it to flash. For example, any distribution from the plan, such as an RMD, will start the flash. A partial rollover could cause the trigger light to flash, as could an in-plan Roth conversion. If the trigger light is flashing and the goal is to complete an NUA transaction, you must move quickly in order to meet the NUA lump sum distribution deadline (discussed below). Once a trigger is activated, the NUA transaction must be completed before the end of that same calendar year. Failure to act promptly and the flashing light will go off, causing that specific NUA trigger to be squandered. (All may not be lost, however, if another trigger event occurs.)
4. Lump Sum Distribution/Timing. A successful NUA transaction requires the entire 401(k) balance to be emptied in one calendar year. (Dividends or other late additions that trickle into the account in the next year will not disqualify the lump-sum payout.) The NUA stock (all or part) is transferred in-kind to a non-qualified brokerage account, and the non-NUA assets are rolled over to an IRA, paid to the account owner as a distribution, or some combination thereof. Failure to empty the account in one calendar year will disqualify the NUA transaction.
Example: Abigail retired two years ago. Her 401(k) is currently valued at $1.2 million. Within her plan is company stock worth $1 million and $200,000 of cash and mutual funds. Her cost basis in the company stock is $300,000. Abigail’s adviser suggests they consider NUA.
Is the stock highly appreciated? Abigail has a net unrealized appreciation of $700,000 in her company stock. The NUA tax break will allow her to pay long term capital gains on this appreciation (no matter how quickly she sells after the distribution) and ordinary income rates on the $300,000 in basis now, in the year of the distribution.
If Abigail did not pursue an NUA transaction and simply did a full IRA rollover, she would pay ordinary income on the entire amount when it is ultimately withdrawn from the IRA. Abigail and her adviser agree that NUA makes sense for her.
Was there a trigger event? Abigail has separated from service, and she was not self-employed. This is a qualifying event that turned Abigail’s trigger light on.
Is the trigger still active? Abigail separated from service two years ago, but she has made no transactions within her plan and taken no distributions. Her trigger light is still on.
Lump sum distribution/timing: Abigail rolls over her $200,000 non-NUA plan assets to her IRA and has the $1 million in company stock transferred in-kind to her non-qualified brokerage account, all within the same year. Abigail will pay ordinary income tax on the $300,000 in basis this year. She has also locked in long-term capital gains rates on the $700,000 of appreciation, regardless of when she sells. (The stock must be held for one year before long-term rates apply to any additional appreciation after transfer into her “regular” brokerage account.)
While Abigail’s example is relatively straightforward, real-life NUA scenarios will present more complex details and nuances. Note that NUA is not an all-or-nothing deal. Abigail and her adviser discussed the tax ramifications of the full NUA distribution. However, if Abigail could not afford the taxes on her entire $300,000 basis, she could have rolled a portion of her company stock to her IRA. NUA would be forever lost on those shares rolled to the IRA, but a partial NUA distribution could have been her best way forward.
The “science” of NUA is fixed – triggers, lump sum distribution rules, tax brackets. It is the adviser who best combines these known elements with the art of understanding each client’s needs who will become an NUA master. Those masters are especially in demand today as more employees and retirees see exploding increases in the value of company stock in their 401(k)s.
About the author: Andy Ives, CFP, AIF, is an IRA Analyst with Ed Slott and Company, LLC with over 20 years of experience with IRAs, retirement plans and investments. Andy has worked directly with financial advisers, third party administrators, mutual fund companies and end-user clients, both corporate and individual.
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