Traditionally, we recommend that most retiring employees roll their 401(k) assets into an IRA rollover account to continue the tax-deferred growth and avoid immediate taxation. IRA assets are eligible for withdrawal without penalty after age 59 ½, with distributions taxed at ordinary income tax rates. Generally, it rarely makes sense to take a cash distribution from your 401(k). However, an exception exists if you have highly appreciated company stock.
Net unrealized appreciation (NUA), occurs when an employer allows an employee to purchase and hold company stock in a qualified plan, such as a 401(k), employee stock ownership plan, or other qualified retirement plan and there is appreciation in the stock above the purchase price. For example, say you have $400,000 of your company’s stock in your plan that you only paid $50,000 for. You have an NUA of $350,000. The unrealized appreciation is the difference between your cost basis and the value of the shares at the distribution date.
When you leave the company or retire, NUA rules allow you to receive the company stock—and only the company stock—from your 401(k) as a distribution. The lump sum distribution of the company stock can then be transferred to a brokerage account. You will owe ordinary income tax only on the cost basis of the shares, not the fully appreciated market value of your company stock. All other assets held in the 401(k) plan must be rolled over into an IRA to avoid ordinary income taxes.
In the above instance, you would pay ordinary income tax rates on $50,000—not $400,000. The NUA of $350,000 is taxed at long-term capital gains rates when you sell the securities, no matter how long you’ve held the securities outside of the plan. Currently, long-term capital gains for most taxpayers are 15% federal plus 6% for Georgia state taxes. Any price increase above the NUA becomes subject to normal capital gains rules when you sell shares. Remember, you’ve already paid tax on the $50,000 cost basis, so you won’t pay tax on that amount again when you sell the stock.
If you rolled over your company stock into an IRA, you would be taxed at your ordinary income tax rate, which can be as high as 39.6% federal and 6% Georgia, when you take distributions from the IRA. Furthermore, assets held in an IRA or left in a 401(k) plan will, after age 70½, be subject to required minimum distributions, which are also subject to ordinary income tax rates.
There are many considerations to work through before you will know if this is the right strategy. First, consider if you would be subject to early withdrawal penalties. NUA does bypass the typical early withdrawal rules. However, the cost basis portion is subject to the 10% early withdrawal penalty. Second, your 401(k) plan must allow for this type of distribution. A thorough tax analysis may be helpful to determine what your tax liability would be today, compared to estimated future tax costs. Always be aware, tax laws and rates are subject to change.
This could be one of the most valuable strategies available to retiring employees; however, it is also one of the most underused tax rules because of its complexity. Before pursuing this option, it is important to plan ahead and seek advice from a qualified tax adviser.
If you hold company stock in your qualified retirement plan, the experts at Henssler Financial will be glad to help:
- Experts Request Form
- Email: experts@henssler.com
- Phone: 770-429-9166.
This article is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
