By S. Joseph DiSalvo, ChFC, and Marie Madarasz, AIF
For many, the pandemic of 2020 has meant leaving a job or taking an early retirement. For others, it has meant a renewed interest in getting their financial “ducks” in a row, which means a greater focus on one of their largest assets: their employer-provided retirement plans.
If you have company stock inside of your 401(k) plan there may be a tax planning opportunity you may not be aware of. Before you make any decisions regarding your 401(k) after leaving employement or turn age 59 ½, read this; we want to share with you a tax savings opportunity that is often missed!
When you retire or leave your job, many assume that the right move is to roll over your retirement funds to an IRA. Not so fast! For many people, a rollover will be a smart decision. However, don’t assume that is always the way to go. In some cases, another option may be the smart choice; if you have company stock inside of your 401(k), a tax break called Net Unrealized Appreciation (NUA) may make taking a different route a good choice.
Are you a candidate for NUA?
Can you benefit from NUA? Well, ask yourself two questions. The first question is, “Do I have company stock in my 401(k)?" The second question is, “Is it highly appreciated?” To determine if the stock is “highly appreciated” (which is a subjective term), look at what the cost was when the shares were purchased vs. what today’s value is of those shares. If the answer to both questions is “yes,” you may be a good candidate for the NUA tax break.
How the NUA Tax Break Works
Here is how the NUA tax break works: You withdraw the stock from the company plan and pay regular income tax on it, but only on the original cost to the plan and not on the market value, i.e., what the shares are worth on the date of the distribution.
The difference (the appreciation) is the NUA. NUA is the increase in the value of the employer stock from the time it was acquired in the plan to the date of the distribution to you. You can defer the tax on the NUA until you sell the stock. When you do sell, you will only pay tax at your current long-term capital gains rate. (Had you acted too quickly and rolled the plan balance to an IRA, you would have lost the NUA tax break and ultimately paid ordinary income tax on the appreciation when it was withdrawn from the IRA.)
Now is the Time to Act – the Triggering Event
To qualify for the NUA tax break, the distribution must occur after a triggering event. Triggering events include: death, reaching age 59½, separation from service (not for self-employed), or, disability (only for self-employed).
The distribution must also be a lump-sum distribution. This means you must empty the entire 401(k) account in one tax year. You can transfer all funds that are not in company stock into your IRA and distribute, in-kind, the company stock to a non-retirement brokerage account. You will pay ordinary income tax on the cost basis of only the stock now and defer the long-term capital gains tax on the NUA until you sell the stock. Depending on your current and future tax bracket, this could represent a significant tax savings. Any additional earnings from the date you transfer the stock out of the 401(k) until it is sold will either be taxed at short-term (if the stock is held for less than one year after transfer) or long-term cap gains rate (if held for one year or longer).
Be careful! Remember, if you roll over the highly appreciated stock to an IRA, you will lose the NUA tax break.
Is NUA Right for You?
NUA sounds like a great strategy. However, it is not for everyone. Is it for you? Well, generally, NUA can be a better strategy than a rollover if you are in a high tax bracket with a good portion of your retirement assets in highly appreciated company stock. You must be willing and able to pay an immediate tax bill on the cost basis of your stock. There are many factors to consider and many pitfalls to avoid.
You Cannot Afford a Mistake with NUA
You may not be aware that a seemingly small violation of the rules can result in the loss of the NUA strategy. The devil here is in the details! Many taxpayers have learned this lesson the hard way. They mistakenly rolled over company stock from their plan to an IRA or they failed to take a lump-sum distribution. They discovered that these mistakes were irreversible and the NUA break was gone forever. Because the consequences are so serious, you cannot afford to make a mistake with the NUA rules.
If you are interested in learning more about NUA and how it could benefit you now or in the future, you will want to consult with a knowledgeable tax or financial advisor.
- Leaving a Job? Should You Roll Over, Stay Put, or Withdraw Your Retirement Plan?
- Two Reasons to Make After-tax Contributions to Your 401(k)
- How to Grow and Protect Your Wealth After Retirement
- Retirement Daily Learning Center: How to Know When to Retire
About the authors: S. Joseph DiSalvo, ChFC®, and Marie L. Madarasz, AIF®
S. Joseph DiSalvo, ChFC and Marie L. Madarasz, AIF, authors of “Income for Life, a Retiree's Guide to Creating Income from Savings,” specialize in coordinating a retiree’s Income, investment and tax planning. They are members of Ed Slott’s Elite IRA Advisor Group, a prestigious study group which enhances their knowledge of IRA distribution planning. Both are strong advocates of financial education, seeking to teach others how to achieve sustained success and lifelong prosperity. www.IncomeForLifeBook.com
Got Questions About Your Taxes, Personal Finances and Investments? Get Answers!
Email Jeffrey Levine, CPA/PFS, chief planning officer at Buckingham Wealth Partners, at: AskTheHammer@BuckinghamGroup.com.