The National Bureau of Labor Statistics did a study in August 2021 looking at the number of jobs that people born between 1957 and 1964, essentially baby boomers, held from age 18 to 56. The report can be found and read here. Any guess on the number of jobs over a person's working lifetime? 12.7 - that's right, 12.7 jobs over their working career. To be fair, half these jobs were held from ages 18 to 24 when you're still trying to figure your place in this world. But that still means during the heart of their career, most people in this age range switched jobs 6 times. Do you think this will get any better with the current generation?
Every one of these job changes creates a series of business transactions that one must think through. New benefit plans, new payroll cycles, new routines, and getting all the business from your former employer wrapped up. The least of which is your former employer's retirement plan. Although individual circumstances must be reviewed, many times, people opt to roll these former employer dollars into their IRA or Roth IRA, depending on the tax treatment of the monies. By the time you do your last rollover, this may feel routine however, the rollover prior to retirement (or around retirement) may be more critical if something called Net Unrealized Appreciation "NUA" is applicable to you. (Note - to be clear NUA can be taken advantage of not just at retirement but for purposes of this article, let's assume that's the most beneficial time to do so).
What is Net Unrealized Appreciation (NUA)?
NUA is a tax strategy that allows individuals to take advantage of potential tax benefits when distributing employer-sponsored retirement plan assets, typically company stock, from their 401(k) plan. This strategy applies when an individual holds employer stock in their 401(k) plan and is planning to roll over their 401(k) balance into an Individual Retirement Account (IRA) upon retirement or job change.
The key concept behind NUA is to differentiate between the two components of your company stock within the 401(k):
Basis: The original cost of the employer stock when it was purchased within the 401(k).
Net Unrealized Appreciation: The difference between the current market value of the employer stock and its original cost or basis.
Let's use a quick example: Johnny works for Tesla. When he started with Tesla in 2018 he bought stock in the company 401(k) plan through 2018 and 2019 but was worried about it becoming too large of a position in his 401(k) (not to mention the stock options he received) so after 2019 he continued contributing to his 401(k) but just allocated new dollars in other mutual fund options available in the plan. Johnny acquired 1,000 shares of Tesla, over the time his contributions went into Tesla stock inside of the plan, and the average price during that timeframe was $20.00 / share, so let's assume that was his average purchase price. Johnny would have a basis in his Tesla stock of $20,000. Then Johnny continued to work for Tesla over the next five years, and here is what happened to Tesla stock over that time frame.
So today, Johnny has 1,000 shares, and the closing price is $244.45, thus, it has a market value of $244,450. That means our friend Johnny has net unrealized appreciation of $224,450 (Current Market Value - Basis).
Why Consider Using NUA?
Using the NUA strategy can offer several advantages for those with substantial employer stock holdings in their 401(k). Here are some compelling reasons to consider NUA when rolling over your 401(k):
Tax Efficiency: Perhaps the most significant benefit of NUA is its potential to lower your overall tax liability. When you use the NUA strategy, you are only taxed on the cost basis of the employer stock at your ordinary income tax rate, at the time of the rollover. The NUA itself is taxed at long-term capital gains rates when you decide to sell the stock. In our example above, if Johnny decided to execute an NUA he would be taxed on the $20,000 (cost basis) at his ordinary income tax rate, but the gain would not be taxable until he sold and would be taxed at the capital gains tax rate. Long-term capital gains rates are 0%, 15%, and 20%, while federal income tax rates are: 10%, 12%, 22%, 24% 32%, 35%, and 37%.
Estate Planning: NUA can also be advantageous for estate planning purposes. When you pass away, the NUA stock is included in your taxable estate at its current market value, potentially allowing your heirs to receive a step-up on the basis of the gains of the stock after the NUA was executed. This means any gains earned after the NUA would likely be tax-free to your heirs. However, any unused NUA gains would be treated as "income in respect to a decedent" and would still be taxed at a long-term capital gains tax when eventually sold by your heirs.
Lower Required Minimum Distributions: Considering that an NUA strategy has you allocate the company stock dollars into a taxable brokerage (or bridge account as Dave Ramsey calls them), these dollars are no longer in your IRA, which is subject to a required minimum distribution somewhere between age 73 - 75 (depending on when you were born) and every year after. Required minimum distributions, if not properly managed, can push clients into higher tax brackets later in life, even creating issues where it would make Social Security and Medicare taxed at higher rates.
How to Implement NUA
To take advantage of the NUA strategy, you must follow specific rules and procedures:
Qualifying Employer Stock: First, ensure that the stock held in your 401(k) qualifies for NUA treatment. It must be employer stock of your current or former employer.
Distribution of Stock: Instead of rolling over the entire 401(k) balance into an IRA, you should request a distribution of the employer stock in-kind. This means that the stock itself is transferred to a taxable brokerage account in your name.
Taxation: You will be taxed on the cost basis of the employer stock in the year of distribution at your ordinary income tax rate. The NUA itself is deferred until you decide to sell the stock, at which point it will be taxed as a long-term capital gain.
IRA Rollover: After the distribution, you can roll over the remainder of your 401(k) balance into a traditional or Roth IRA. The NUA portion remains in the taxable brokerage account.
Selling the Stock: You can sell the employer stock at any time, but it's essential to consider your tax situation and financial goals when deciding when to do so.
Should You Consider NUA?
Certified Public Accountant (CPA) at Whitaker-Myers Tax Advisors Kage Rush reminds clients, "While you should never let tax implications and decisions be the only factor when making investment decisions, some general considerations make NUA attractive to certain individuals." If you can answer yes to these conditions below, you may be a good candidate:
Are you 59 1/2 (doing so before may open you up to a 10% early withdrawal penalty)?
Are you taking Required Minimum Distributions soon?
Is your current tax rate similar (or lower) to what it'll be in retirement?
Will doing an NUA give you a compliment of tax-diversified assets (taxable, Roth, pre-tax IRA)?
NUA Tax Treatment Rules
There are some general rules you must follow to ensure that the stock moved into the taxable brokerage account is treated with the NUA rules. If not followed, this can cause your NUA election to be disqualified by the IRS, thereby making the entire distribution taxed at ordinary income tax rates. If you'd like to spend time in the weeds of the IRS publication like Kage and I have to write this article, you can visit that here. Below is a summary of the rules:
You must have reached one of the following:
A. Separation of service from the company with whom the stock is held.
B. Death
C. Disability (but this provision only applies to self-employed workers
D. 59 1/2 - The typical retirement age or in-service withdrawal age for most plans
2. The entire vested account balance must be distributed within one year. Considering that the NUA transfer may happen first, you don't need to make the entire account distribution in one transaction, it just must be gone within one year.
3. You must distribute all assets from all qualified plans from the employer. This is even if any other plan at the company didn't hold company stock.
4. The transfer to the taxable brokerage must go in actual shares. You can't have the stock sold and turned to cash (and subsequently repurchased).
Conclusion
Net Unrealized Appreciation (NUA) is a valuable strategy for individuals who hold employer stock within their 401(k) plans. According to an article published by Fidelity in February of 2023, nearly 2 million of their customers hold stock in 401(k) or other workplace retirement plans. By understanding the potential tax advantages, diversification benefits, and estate planning possibilities that NUA offers, you can make an informed decision when rolling over your retirement savings. However, NUA is a complex strategy with tax implications, so it's crucial to consult with a financial advisor or tax professional before implementing it to ensure it aligns with your overall financial plan.