Employer-sponsored retirement plans can provide significant tax advantages, and some strategies require precise planning to manage your savings effectively. One powerful option is the net unrealized appreciation (NUA) strategy, which can potentially save you tens of thousands in taxes if executed correctly.
However, because NUA tax treatment is complex, it’s important to understand the basics before deciding if NUA could be a good fit for your situation. Here’s how to leverage NUA to help you keep more of your hard-earned retirement savings and avoid being taxed twice.
What Is Net Unrealized Appreciation (NUA)?
Net Unrealized Appreciation (NUA) is a tax strategy for company stock held within a 401(k). It allows you to separate the stock’s value into two parts for tax purposes, potentially saving you thousands by leveraging lower capital gains rates.
How NUA Works in a 401(k)
NUA is the growth (appreciation) over the basis (what you paid) of the stock. Here’s how it works in a nutshell:
- Cost basis: The IRS taxes the original amount paid for the shares of stock as ordinary income upon distribution.
- Appreciation (NUA): The IRS doesn’t tax the profit (current value minus cost basis) until you sell the stock. Crucially, the IRS taxes the entire gain at the lower long-term capital gains rate, not higher ordinary income tax rates.
Simply put, you take what you paid for the stock and subtract that from the current price: This leaves you with your NUA. The net unrealized appreciation strategy for 401(k)s may not only help secure a lower tax rate on the growth but also avoids the 3.8% Net Investment Income Tax, making it a powerful tool for eligible retirees.
Why Consider an NUA Strategy?
NUA strategy can be an effective tool to help avoid the higher income tax rates typically applied to traditional 401(k) and IRA distributions. By converting what would normally be taxed as income into assets taxed at preferential long-term capital gains rates, this approach may allow you to preserve more of your retirement savings for you and your heirs over the long term.
Key Risks and Drawbacks of NUA
While an NUA strategy can be a tax home run, it’s not exactly a no-brainer and can come with some serious strings attached. So it’s important to understand Net Unrealized Appreciation rules and the associated risks:
- Up-front tax hit: The biggest catch is the immediate tax bill. You’ll have to pay ordinary income tax all in one year on the entire original cost of the stock (your cost basis). You’ll need cash to cover this tax without dipping into the distributed shares.
- “All-or-nothing” rule: NUA isn’t a pick-and-choose game. You have to distribute all shares of the company stock you hold from the plan within the same calendar year to qualify for the special NUA tax treatment. You can’t just distribute a portion of your holdings.
- Losing the “do-over”: Once you trigger an NUA, the decision is irreversible. You can’t later decide to roll those shares into an IRA. You’re locked into the tax consequences of your choice.
- Timing and eligibility pitfalls: The NUA strategy is only available under specific conditions, like a separation from service or reaching age 59.5. Missing a single rule in the complex IRS requirements can disqualify the entire strategy, leaving you with a massive, unexpected tax bill.
How to Capitalize on NUA in Your Retirement Plan
To take advantage of NUA, you need a smart game plan that looks at your specific holdings and distribution timing. You’ll likely need the guidance of an experienced financial advisor or tax professional.
Evaluate if Employer Stock Makes Sense
Before deciding whether NUA tax treatment makes sense for your employer’s stocks, you should run the numbers. The NUA strategy works best when the stock has significantly appreciated, meaning the NUA (the unrealized gain) is high relative to your original cost basis.
You’ll also need the cash on hand to cover the large, immediate tax bill on that cost basis. Essentially, if your stock has low growth or you can’t handle the upfront tax hit, an NUA strategy may not be for you.
Time Your Distributions Strategically
Strategically timing your NUA distribution may help with your tax liability. The ideal moment is often in a year when your taxable income is unexpectedly lower than normal, as this can help keep the ordinary income tax hit on your cost basis in a lower tax bracket.
Many retirees execute their distribution in the first year of retirement, before required minimum distributions (RMDs) kick in. This way, they can avoid stacking this large income event on top of other mandatory withdrawals and pushing themselves into a higher tax bracket.
Work With a Financial Advisor to Maximize Benefits
An NUA strategy is full of complicated tax rules where one wrong move can lead to a large tax bill that could have been avoided. That’s why working with a financial advisor is so important to help guide you. They can crunch the numbers to see if an NUA strategy may help save you money compared to a simple rollover.
NUA Strategy vs. Standard Rollover: A Tax Comparison
| Feature | Using NUA Strategy | Not Using NUA Strategy (Standard Rollover) |
|---|---|---|
| Company Stock Treatment | Distribute shares "in-kind" to a taxable brokerage account | Roll all assets into a Traditional IRA |
| Tax on Cost Basis | Ordinary income tax due in the first year on the stock's original cost | Deferred, no immediate tax |
| Tax on Growth (NUA) | Long-term capital gains rates on the growth when you sell | Ordinary income tax rates on all withdrawals (principal + growth) |
| Future Tax Rate on Growth | Typically lower (LTCG rates are often lower than income tax rates) | Typically higher (taxed at your future ordinary income tax rate) |
| Required Minimum Distributions (RMDs) | No RMDs on the stock in the brokerage account | Yes, subject to RMDs on the entire IRA balance starting at age 73 |
NUA Tax Treatment Explained with a Hypothetical Example
So how does an NUA strategy work in practice? Here’s a hypothetical example:
Jane invested $150,000 in her company’s stock within her 401(k), and it’s now worth $650,000. Normally, withdrawing the full amount would tax the entire $650,000 at her ordinary income rate—let’s assume 24%—resulting in a tax bill of $156,000.
Using an NUA strategy can split the tax treatment as follows:
- The IRS taxes her original $150,000 (her cost basis) as ordinary income in the year she withdraws the stock.
- The IRS taxes the $500,000 growth (the NUA) at the lower, long-term capital gains rate (let’s assume 15%) only when she later sells the shares.
This changes her total tax bill to $111,000. That’s ($150,000 x 24%) + ($500,000 x 15%). Thus, Jane saves $45,000 in taxes.
Partner with a Financial Advisor to Help Maximize NUA
Pulling off an NUA strategy correctly can be a complex undertaking. That’s why it’s important to work with a financial advisor with expertise in NUA tax treatment. Partner with a Carson Wealth advisor today to learn whether you could benefit from an NUA strategy.
FAQs
What is the main benefit of NUA?
The main benefit is paying lower long-term capital gains rates, instead of higher ordinary income taxes, on the appreciation of employer stock.
Is NUA always a good idea?
No, NUA is generally beneficial when the stock has significantly appreciated and you can afford the upfront tax on the cost basis.
Can I combine NUA with other retirement strategies?
Yes, but it requires careful coordination with other income and distributions to avoid pushing yourself into a higher tax bracket.
Does NUA count towards RMD?
No, once distributed, the shares are no longer part of your retirement account and are not subject to required minimum distributions (RMDs).
Distributions from traditional IRAs and employer sponsored retirement plans are taxed as ordinary income and, if taken prior to reaching age 59 1/2, may be subject to an additional 10% IRS tax penalty.
This content is for general information only and is not intended to provide specific legal, tax, or other professional advice. No strategy assures success or protects against loss. To determine what may be appropriate for you, consult with your attorney, accountant, financial or tax advisor.
8584241.1.-1125-C
