If you own stock from your company in your 401k, you should think carefully before deciding to do a 401k rollover.
The IRS offers a provision for the Net Unrealized Appreciation (NUA) on the value of the employer stock held in your 401k plan. If certain qualifications are met, you may choose to distribute your employer stock in a manner to help you receive more favorable tax treatment on the gains (if any) in your company stock shares.
The net unrealized appreciation (NUA) is the difference in value between the cost basis of shares of employer stock and the current market value of the shares. Typically, distributions from a 401k account are taxed as ordinary income.
When company stock is held in a tax-deferred account, however, the IRS provision allows for the NUA to be taxed as a capital gain, rather than as ordinary income. Since long-term capital gains tax rates are generally more favorable than ordinary income tax rates, this can be a way to save on taxes, particularly if your company stock has appreciated a lot.
Let's look at an example. Let's say you've worked with your company for many years, and you've invested in the company stock fund every year as you've saved for retirement. You've built up the company stock to a value of $500,000 at the time you retire.
But, since you bought the stock at lower prices when you first invested, the cost basis (the price you paid for the stock) might only be $200,000.
In this case, your unrealized appreciation would be $300,000. If you utilize the NUA provision, you could distribute the entire $500k of employer stock into a taxable brokerage account in kind. You would owe ordinary income tax on the cost basis ($200k) immediately when it's distributed, but the $300k in gains would then be eligible to be taxed at long term capital gains rates (typically 15%, depending on your total income).
If instead you rolled the balance of the 401k over to an IRA, you would no longer be eligible for the NUA provision. The $300k in gains would instead be taxed at ordinary income tax rates at the time you withdraw the funds from the IRA. If your ordinary income bracket is above 15%, you would end up paying more tax on this balance when you withdraw the funds.
There are a couple of situations where the use of the NUA provision may be favorable.
If the company stock has appreciated greatly, and your ordinary income tax bracket will be higher than the long-term capital gains rates, you may benefit from utilizing the NUA provision.
If you can distribute some portion of the company stock and remain in the 12%- or lower-income tax brackets (when accounting for the distribution and all other sources of income and capital gains), you may be eligible to realize the long-term capital gains at a 0% tax rate, under current tax law.
You should also have cash available to pay the tax due on the distribution of the cost basis at the time of distribution.
The NUA provision is only available for company stock held in tax-deferred accounts, and only for the stock of the company for which you are or were employed.
Certain requirements have to be met to qualify for the NUA provision. The company stock must be distributed in-kind (meaning not sold) into a taxable brokerage account. Ordinary income taxes are due on the cost basis of the distributed shares immediately.
The remaining balance of the 401k plan must be rolled over or distributed in total within 1 year of the employer stock distribution.
You also must have either separated from the company, reached the minimum retirement age for distribution, suffered an injury resulting in total disability, or you must have died.
The potential advantage of using the NUA provision is that if you have a lot of appreciation in the company stock, this option can allow you to have the gains taxed at capital gains rates, rather than as ordinary income. Depending on the amount of the gains, this may be a considerable tax savings.
One downside to this approach is that ordinary income tax is due immediately on the cost basis of the shares.
If you are a manager or director in your company, you may have company stock in your 401k plan.
It’s best to consider all your options and consult with your financial planner and tax professional before making a decision on using the NUA provision and before requesting a 401k rollover. Knowing your tax situation at retirement and in future years can help you determine if using the NUA provision is right for you.