Are you one of the 2+ million Fidelity customers who holds company stock in a 401(k) or other workplace retirement savings plan?
If so, you should know about a tax break that could save you a bundle —if you qualify.
Anyone who owns company stock will eventually have to decide how to distribute those assets—typically when you retire or change employers. Taking a distribution could leave you facing a big tax bill, but a little-known tax break—taking advantage of net unrealized appreciation (NUA)—has the potential to help.
"With appreciated company stock, you'll face the question of what kind of taxes—capital gains vs. ordinary income taxes—you will wind up paying on the gains of your company stock holdings over time," says Mitch Pomerance, vice president and financial consultant at Fidelity Investments.
"With NUA, when you have company stock in your qualified retirement plan, such as your 401(k), and take a lump-sum distribution from a qualified retirement plan, you can effectively pay lower capital gains rates on a portion of your tax-deferred assets instead of paying the typically higher ordinary income rates when assets are withdrawn from the tax-deferred account," explains Pomerance.
NUA is the difference between the price you initially paid for a stock (its cost basis) and its current market value. Say you can buy company stock in your plan for $20 per share, and you use $2,000 to purchase 100 shares. Five years later, the shares are worth $35 each, for a total value of $3,500: $2,000 of that figure would be your cost basis and $1,500 would be NUA.
Why should you care about NUA? When you want to distribute company stock or its cash value out of your 401(k), you will face a choice: Roll it into an IRA (or another 401(k) plan), or distribute the company stock into a taxable account and roll the remaining assets into an IRA or 401(k). The latter option might be more effective, depending on your circumstances, thanks to IRS rules governing NUA.
When you transfer most types of assets from a 401(k) plan to a taxable account, you pay income tax on their market value. But with company stock, you pay income tax only on the stock’s cost basis—not on the amount it gained since you bought it. (If you are under age 59½, you may also pay a 10% early withdrawal penalty.) Remember, upon direct, in-kind transfer to an IRA the special NUA tax advantages for company stock are lost.
When you sell your shares, you’ll pay long-term capital gains tax on the stock's NUA, along with any additional capital gains that occur after you make the distribution. The maximum federal capital gains tax rate is currently 20%, far lower than the current 37% top income tax rate, so your potential tax savings may be substantial.
"In general, if the cost basis is low, relative to the size of the stock position in your 401(k), it may make sense to take the tax hit now, rather than later on the full amount," says Pomerance.
When to choose an NUA tax strategy
Consider the following 4 factors as you decide whether to roll all your assets into an IRA or to transfer company stock separately into a taxable account:
Tax rates. The larger the difference between the ordinary income tax rate and the long-term capital gains tax rate, the greater the potential tax savings of electing an NUA tax treatment of company stock.
Absolute NUA. The larger the dollar value of the stock's appreciation, the more the NUA rule can save you on taxes.
Percentage of NUA. An NUA that is a higher percentage of total market value creates greater potential tax savings because more of the proceeds will be taxed at the lower capital gains rate and less will be taxed at income tax rates.
Time horizon to distribution. The longer you plan to keep your assets invested in an IRA or taxable account before liquidating them, the greater the potential benefit of tax-deferred growth, and therefore, the less you would benefit from NUA. A shorter time frame, on the other hand, makes the NUA election more attractive.
How NUA stock is generally taxed
|Cost basis||Immediately taxable as ordinary income when NUA distribution takes place after qualifying event (may be subject to 10% early withdrawal penalty)|
|NUA gain||Taxable as long-term capital gains when company stock shares are sold|
|Post-distribution gain||Taxed at short or longer-term capital gains rates based on the holding period from the distribution date|
Two scenarios: When does NUA make sense?
Let's look at 2 hypothetical NUA scenarios. Both workers had long careers and contributed to their company's qualified retirement plan for many years. Both are faced with sizable tax bills on their account balances.
Scenario 1: Utilize NUA and buy down the basis now to save on taxes in retirement
Here's a hypothetical scenario where NUA makes sense. After a 40-year career in the defense industry, Tony, age 67, recently retired with $2 million in his 401(k). He is widowed and currently in the 24% federal tax bracket. About half of Tony's $2 million nest egg is company stock worth approximately $1 million. Because he participated in the company's plan for many years and purchased the stock at low share prices over time (the average basis vs. the current share price), the actual cost basis of his company stock is only $50,000.
While still working earlier this year, Tony, whose recent annual salary was $100,000, made a $40,000 after-tax contribution to his 401(k) to buy down the basis of his company stock. Under his company's retirement plan rules, he is allowed to use this money to reduce the baseline value on which taxes will be based, allowing his taxable income to stay in the 24% federal tax bracket. If you have made after-tax contributions, that tax basis will automatically ascribe to anything you don't directly roll over when you take the full payout including the stock.
When Tony's required minimum distributions (RMDs) start in a few years, he's projected to be in the 22% federal tax bracket. To take advantage of NUA, after he retired this year, he requested a full distribution of his 401(k) account, sending the company stock in-kind to a taxable brokerage account, and directly rolling over the rest to an IRA. Now, he'll only pay tax at the ordinary income rate on $10,000 worth of the basis on the company stock, and he won’t be taxed on the gain on the company stock, valued at $1 million, until he sells it. The other $1 million or so stays in the IRA to pay for future retirement expenses or to give away to charities and family.
Down the road when Tony passes away, if he hasn’t yet sold the company stock, his children can get a step-up in basis on it (under current law). While they may be subject to estate or inheritance tax when they inherit the company stock, they will not need to worry about income or capital gains taxes on the company stock. If estate or inheritance tax is an issue, Tony could also consider the transfer of the company stock to an irrevocable trust as part of his estate planning strategy, working with a qualified estate planning attorney. Note: If the account holder dies before selling or transferring assets, the heirs do not receive a stepped-up basis on those assets because the NUA is considered "income in respect of a decedent" and is still taxable as a long-term capital gain.
"Like a Roth conversion, NUAs should be realized primarily because you want to pay a lower tax rate on assets in the future by paying some taxes in the present," explains Pomerance. “You also are able to potentially reduce future RMDs by getting the assets out of the retirement plan accounts.”
|Value of company stock||$2,000,000|
|After-tax contribution to 401(k) to buy down the basis of company stock||$40,000|
|Estimated tax bracket when investment gains are paid||24% tax bracket|
|Estimated first year’s taxes||$2,400|
|Estimated RMD amount at age 72, assuming 7% growth rate and no NUA election||$112,000|
|Estimated RMD amount at age 72, assuming 7% growth rate and taking advantage of NUA||$56,102|
|Difference in estimated yearly taxes vs. utilizing non-NUA approach starting at age 72||$12,341*|
|Estimated tax bracket in retirement (assumes he takes advantage of NUA option)||22% tax bracket|
|For illustrative purposes only. State and local taxes not considered. * Calculation: ($112,200-$56,102) times 22% tax bracket = $12,341|
Scenario 2: Don't utilize an NUA approach because taxes are estimated to be lower in the future
In some scenarios, however, income in retirement may be much lower than the current level and the effective ordinary income tax rate may be lower, so the investor may be better off not doing an NUA but by simply rolling the company stock directly into an IRA.
In the following hypothetical scenario, consider Irwin, age 65. He's had a long career in biotech as a senior executive and earns about $500,000 a year, putting him in the estimated federal tax bracket of 35%.
He just retired from one company with $2,500,000 in his 401(k) plan, of which $500,000 was invested in company stock. NUA is $250,000. Although, that's a nice nest egg, Irwin is at the peak of his earnings capacity, loves what he does, and will almost certainly continue working for another 5 years after he leaves his current position and company this year.
Looking a few years down the road, Irwin would retire at age 70. Assuming all assets from his former employer’s 401(k) were rolled into an IRA, he would have projected annual income from his investments of $170,000, and estimated RMDs of $154,000 at age 72. That should put him in the 24% federal tax bracket vs. his current tax bracket of 35%.
In Irwin's case, if he exercised NUA, it would put him in a 37% bracket today and further increase the taxes to be paid on NUA. So, NUA doesn't make sense, given his high level of current income, along with the anticipation that his tax bracket will likely be lower in the future.
|Not utilizing NUA|
|Value of company stock||$500,000|
|Estimated tax bracket if not exercising NUA||35%|
|Estimated tax bracket if exercising NUA||37%|
|Estimated first year taxes on NUA||$92,500|
|Taxes on same amount at age 72 at 24% rate||$60,000|
|For illustrative purposes only. State and local taxes not considered. Estimates are based on the subject filing taxes with the IRS as "married and filing jointly." Estimated rate of growth on company stock: 6%.|
Is NUA right for you?
It generally makes sense to utilize NUA when you believe your current tax rate is the same or lower than what you expect it to be in the future. Consider the following 3 conditions, which may indicate that your income will not fall sharply in the future and may even rise:
If yes is answered to all 3 conditions, an NUA may be to your advantage, although it’s no guarantee, so be sure to consult with a tax advisor or financial planning professional regarding your personal situation before making any decisions.
"In general, it's important to work out the various tax scenarios because you'll eventually have to pay taxes on gains from selling company stock," says Pomerance. "However, you don't want to let taxes dictate investing decisions. Working with your Fidelity financial professional or on your own, make sure to first consider the sale of NUAs in light of your asset allocation, cash flow needs, and long-term retirement goals—then consult your tax advisor to make the determination if this tax strategy makes sense for you."