Net unrealized appreciation is an underused and often unknown tax planning opportunity for those who own company stock inside a 401(k) plan.
For many of the employees that participate in an employer-sponsored 401(k) plan, the assumption is that when money is withdrawn from the plan, it will be taxed at ordinary income tax rates. For the most part and in most circumstances, this is true.
However, net unrealized appreciation may allow for a portion of the account to be taxed at preferential long-term capital gains rates.
The greater the percentage of your overall wealth that is tied up in company stock and the greater the spread between the cost basis and the fair market value, the larger the planning opportunity will be.
A Simple NUA Example
Let’s assume a hypothetical 65-year-old retiree with $1,500,000 in an employer-sponsored 401(k) plan. Lets further assume $500,000 of the total account balance is invested in company stock and that this stock has a cost basis (what you paid for it) of $75,000.
(For those who are saying there is no basis because this is all pre-tax dollars, I hear you. You are correct in saying this is pre-tax dollars. However, the company stock in the plan does have basis, which, to be fair, is often irrelevant. However, for net unrealized appreciation purposes, it becomes relevant).
In short, the retiree has a number of options, which we will try to simplify. Therefore we assume the options for this retiree, as it relates to the 401(k) plan, are as follows:
Keep the money in the 401(k) and/or roll it over to a tax-deferred IRA.
Use Net Unrealized Appreciation
Option 1 – Keep the Money in an IRA
If the retiree chooses option one, any and all distributions from the tax-deferred account will be taxed as ordinary income. This is very simple with very little planning opportunity.
Still, this is the most common solution.
Option 2 – Use Net Unrealized Appreciation
The second option is to take advantage of Net Unrealized Appreciation. Here is how it works:
The retiree elects to take the company stock out of the 401(k) and directs this stock into a non-IRA brokerage account.When this transaction occurs, it is a taxable event and is reportable on the calendar year tax return.
The amount taxable to the retiree is ONLY the cost basis of the company stock.
Any capital gain in company stock (the difference between the cost basis and the fair market value) is immediately eligible for preferential long-term capital gains treatment.
The remaining 401(k) account balance is rolled into an IRA in a non-taxable event.
The Potential Value of NUA ‒ A Tax Comparison
A simple tax calculation that compares the income tax allows us to illustrate the potential value of net unrealized appreciation.
In this example, we assume that the current fair market value of company stock is $500,000 and that the cost basis of the stock is $75,000.