Potential Tax Benefits of Net Unrealized Appreciation

By: Cameron Edson, CPA, Assistant Tax Manager

What is Net Unrealized Appreciation

Net Unrealized Appreciation (“NUA”) is the difference in value between the cost basis of company stock held by the taxpayer in their company’s 401(k) plan, and its market value at the time it is distributed from a plan as part of a lump-sum distribution. To determine if the strategies explored in this article are appropriate for your specific situation, please consult with your financial advisor or CPA.

Normal Distributions from a 401(k)

The rules surrounding 401(k) plans stem from the Internal Revenue Code (IRC). The two most common types of 401(k) plans are traditional (also commonly known as “pre-tax or tax deferred”) and Roth (also commonly known as “post-tax”) plans. The traditional 401(k) plans are what we will be focusing on in this article. Contributions made to a traditional 401(k) account reduce the taxpayer’s income in the current year, and no tax is paid on that amount contributed to the 401(k). In addition, any appreciation of the investments held within a 401(k) account is not taxed either. However, once an amount is withdrawn from the traditional 401(k) account in subsequent years, the amount is taxed. The amount withdrawn is taxed at ordinary income tax rates to the taxpayer.

Generally, individuals are allowed to make withdrawals from their 401(k) accounts once they reach the age of 59 ½. Withdrawals made prior to this age (barring a few exceptions) are subject to a 10% early withdrawal penalty.

Options for Traditional 401(k) Withdrawals

Once a taxpayer retires or leaves a company, and they have been awarded company stock in their traditional 401(k) account, taxpayers often have to make a decision on how to withdraw that money. Generally, employers restrict 401(k) plans to current employees of the company.

Taxpayers often make one of four choices (or a combination of choices) when withdrawing from their 401(k) plans:

• Take a withdrawal as a cash distribution,
• Roll their investment holdings into a traditional Individual Retirement Account (IRA),
• Roll their investment holdings into a subsequent employer sponsored 401(k) plan, and/or
• Roll their company stock into a taxable investment account and roll the remaining investment holdings into a traditional IRA account

Taking a withdrawal as a cash distribution requires the 401(k) plan administrator to sell the investment holdings within the plan, and distribute the funds to the taxpayer in cash. As mentioned above, a cash distribution from a withdrawal from a traditional 401(k) account is taxed at ordinary income tax rates to the taxpayer which are based on their taxable income level in the year of distribution. The amount which is taxed is the value of cash received. This is essentially the fair market value of what the investments were sold at, which includes both the original cost basis of the investment, as well as the earnings growth incurred on the investment.

Rolling investment holdings from a traditional 401(k) plan into either a subsequent employer sponsored 401(k) plan or traditional IRA requires no tax outlay from the taxpayer. IRA accounts are also tax deferred accounts and have very similar tax benefits to those of 401(k) plans. Specifically, investments are allowed to grow tax-free within the IRA account, and tax is only incurred to the taxpayer once a distribution from the IRA occurs. In addition, distributions from an IRA to the taxpayer require the IRA administrator to sell the investment holdings and provide the cash to the taxpayer as a distribution, which is the amount that gets taxed at ordinary income tax rates.

Finally, another option for some taxpayers to consider is to roll any company stock into a taxable investment account and roll the remaining investment assets into an IRA. The rolling of the additional investment holdings into the IRA is treated the exact same as previously mentioned: no tax is incurred by the taxpayer. However, rolling the company stock held within the 401(k) account into a taxable investment account isn’t treated the same way. Because investment accounts are taxable accounts, this means the taxpayer is treated as making a withdrawal of the securities from their 401(k) plan, and then contributing those securities to their investment account. This “withdrawal” is subject to income tax. However, as discussed later, only the cost basis of the company stock (i.e., the price it was originally acquired at) is taxed at ordinary rates immediately. The NUA on that company stock is taxed differently.

Applying NUA to a 401(k) Withdrawal

Normally, as mentioned previously, income tax liability is based on the fair market value of the withdrawal at ordinary income tax rates. However, if invested within a taxable investment account, withdrawals of company stock from that company’s 401(k) plan are only taxed on the stock’s cost basis, and not on the NUA (i.e., the growth) earned on that stock since it was acquired. IRS Notice 98-24 and IRC Section 402(e)(4)(B) provide that in the case of a lump sum distribution which includes employer securities, the net unrealized appreciation attributable to the employer securities is excluded from gross income. In addition, as long as the NUA is taxed in a later transaction (i.e., the selling of the stock in a later year), the NUA is then taxed at long-term capital gains (LTCG) rates. LTCG rates are much lower for taxpayers in higher income tax brackets – taxed at 0%, 15%, or 20% depending on the taxpayer’s taxable income level. Whereas the highest ordinary income tax rate is currently 37%.

NUA tax treatment is generally more beneficial for taxpayers who have large amounts of highly appreciated company stock and can afford the additional tax liability incurred from the cost basis of the company stock right away. This provides an opportunity for taxpayers to pay the lower LTCG tax rate in subsequent years when the company stock is sold from their investment account.

How to Receive NUA Tax Treatment

In order to qualify for NUA tax treatment, taxpayers must meet all four of the following criteria:

• The entire vested balance of the 401(k) plan must be distributed within one tax year. However, the entire amount does not need to be distributed at once,
• All assets from all qualified plans held with the employer must be distributed, even if only one of the plans holds the company stock,
• The company stock must be distributed as actual shares. Conversion to cash prior to distribution is not allowed, and
• Taxpayers must experience one of the following:
  1. Separation from service from the company whose 401(k) plan holds the stock (except self-employed workers),
  2. Reached age 59 ½,
  3. Total disability (self-employed workers only), or
  4. Death

NUA Example

Married Filing Jointly Taxpayer Retires in Year 0                                                 

Salary in Year 0 = $500K                                                

Projected Distributions after retirement = $500K per year over 10 years                                                 

Total traditional 401(k) assets valued at $5M                                                     

Includes company stock with value of $2M and basis of $200K                                                   

Scenario 1                                                        

All traditional 401(k) assets rolled into traditional IRA in Year 0                                                   

Distributions begin Year 1                                                         

Scenario 2                                                        

Non-company stock assets rolled into traditional IRA in Year 0                                                    

Company stock rolled into investment account in Year 0

Distributions begin Year  - pro-rata between non-company stock assets and company stock