Net Unrealized Appreciation: A Super Hero Tax Strategy

In its simplest form, net unrealized appreciation (NUA) is an IRS tax provision. When used appropriately in conjunction with your employer sponsored plan (your 401k), it can lower your overall tax burden. To better understand how this is possible, we need to understand how traditional distributions from a 401(k) work, and when an NUA strategy may be appropriate.

Your average 401(k) offers 32 investment options. The majority of these will be in the form of mutual funds, but on occasion, companies offer additional investment types such as Exchange Traded Funds (ETFs), Individual Stocks, and Money Markets. In retirement, and/or the distribution phase, when you withdraw money from a traditional 401(k), those withdrawals are taxed at your ordinary income tax rate. This assessed tax rate is levied on both what is known as the cost basis (think of this as original deposits), as well as appreciation (the growth portion of said deposits).

In some cases, your 401(k) will allow for the individual stock offering to be company stock. When this is the case, net unrealized appreciation may come into play. For example, let’s assume the original cost of said company stock was $100,000 (this is your cost basis). At retirement, that same stock has a market value of $400,000. That difference in value, a gain of $300,000 in this case, is known as net unrealized appreciation, or NUA.

So how can NUA be used to your advantage?

Depending on your personal circumstances, when you leave/retire from your employer, you have the option to rollover your 401(k) into an Individual Retirement Account (IRA)*, a type of account that tends to have more advantages than a 401k (we will cover these in a separate, future article). To participate in NUA, during this rollover process, you will need to think about your 401(k) holdings in two distinct groupings- company stock and noncompany investments within the 401(k) - typically mutual funds. During this transition period, the noncompany investments within the 401(k) will be rolled over into an IRA and the company stock will go directly to a taxable individual investment account. Let’s look at the tax implications of this split:

• Money rolled over into the IRA: This money will eventually be taxed as ordinary income upon distributions.

• Money within the individual investment account: This account holds the company stock, but on paper, this stock has a cost basis, as well as growth. The cost basis will be taxable in the year that you make this transition. It will be taxed as ordinary income for that tax year. From our example above, this is the $100,000. The remaining portion, referred to as the gain in the company stock, will not be taxable until you sell the stock, and the portion originally noted as gain (the $300,000 in this example) will be taxed at long-term capital gains rates at the time of sale, instead of ordinary income tax rates.

Now you may be thinking to yourself “if it’s still taxed, what’s the big deal?” The key here, and the advantage of the net unrealized appreciation strategy, is that it’s taxed at long-term capital gains rates, instead of ordinary income tax rates. Long-term capital gains rates are typically lower than ordinary income tax rates. To better understand this, let’s look at what taxes could look like on this, for a single individual in Washington state:

Example parameters:

• Cost basis of company stock is $100,000
• Gain in company stock is $300,000

Option 1 - Rollover to IRA (Not utilizing NUA): Let’s assume a marginal tax rate of 22% on withdrawals of this company stock over time. In this scenario when being distributed from an IRA or your 401(k), this rate applies to both the $100,000 cost basis, and $300,000 of growth, for a total of $400,000 being taxed at 22%. This comes out to taxes amounting to $88,000 - with a net income of $312,000 left over.

Option 2 - Utilizing NUA: With ordinary income taxes owed for the tax year in which the transfer of company stock to the individual investment account takes place - let’s assume an ordinary income tax rate of 24% here assuming this individual will also have other income sources bumping up their tax rate in the year they retire. $100,000 in this example is taxable this year. That means $24,000 of taxes for this portion. Further, given NUA allows for a long-term capital gains rate to be accessed on the growth of the company stock value at transfer, $300,000 in this instance, that would mean 15% (long-term capital gains rate) is assessed on this portion, amounting to $45,000 in taxes. Altogether, this comes out to taxes amounting to $69,000 - with a net income of $331,000 left over.

In this example, there is a $19,000 savings in taxes - amounting to over 21% of savings in taxes. As a rule of thumb, we can gather the larger the difference between the original cost basis of company stock, and the current value of said stock- the more beneficial a strategy involving NUA becomes.

There are many data points to consider when discussing an NUA, and remember, not everyone’s employer sponsored 401(k) plan offers company stock. For this reason, discussing the impact of utilizing NUA with your Financial Advisor and your Certified Public Accountant (CPA) is always suggested.

Things to keep in mind:

Do I have to do this with all company stock within my 401(k)? No. You can portion this out, however it is only possible to enact an NUA strategy when you rollover your entire 401(k).

Can I do this prior to retirement? It depends on your specific situation. Please speak with your Financial Advisor and CPA to clarify.

Do I need to send in my tax payment for the NUA immediately? No. Taxes will be due by the tax deadline in the given year as per usual (typically April 15^th).

Will this benefit be passed on to whomever inherits my individual investment account? No. This benefit is not transferrable to heirs.

If your employer offers the option to purchase company stock within your 401(k) and you would like to explore this concept further with a CWM advisor, Contact Us or call (425) 778-6160 to schedule a conversation!

*It is important to understand your options when considering rolling over assets from an employer sponsored retirement plan into an individual retirement account (IRA) or from one IRA to another. Retirement plans and IRAs involve investment-related expenses (e.g., commissions, mutual fund expenses or investment advisory fees) and plan or account fees (e.g., recordkeeping, compliance, trustee fees and fees for services such as access to a customer service representative). These expenses and fees negatively impact investment performance.

Please review the advantages, disadvantages, and considerations, with your financial professional prior to deciding the best option for your retirement assets.

Comprehensive Wealth Management, LLC does not offer tax advice. Please consult with your Certified Public Accountant for specific tax questions.