Many people hold shares of their employer's stock in their company-sponsored retirement account. When the time comes to roll your 401(k) over, you need to understand the tax implications of employer stock net unrealized appreciation, and be sure to use the right strategy. While the right approach can leave you with a lot more money, the wrong one could cost you thousands in avoidable taxes.
What is net unrealized appreciation?
Net unrealized appreciation -- also called NUA -- is the difference in your cost basis (what you paid) and the current market value of shares held in a tax-deferred account.
Let's say, for example, that you hold 10,000 shares of your employer's stock in your retirement account that you bought at $10 per share. Your cost basis in this case is $100,000. If the market value of the stock subsequently rose to $40 per share, making your stock worth $400,000, then the net unrealized appreciation would be $300,000 -- the difference between your cost basis and the market value.
How it can save (or cost) you money
It's commonplace to rollover your 401(k) when you retire or change jobs. In most cases, the logical step is to rollover your funds to an IRA or your new employer's 401(k), in order to maintain the tax-deferred benefit of your nest egg. If you move your assets into a taxable account, you'll lose the tax-deferred status of those funds, and every dollar gets treated as income for that year. In other words, it's almost always best to rollover into another retirement account.
But in the case of employer stock, it might be worth taking a taxable distribution, especially if your employer stock has gone up significantly in value. This is where NUA comes into play.
Using the example above, NUA would limit your taxes to only the $100,000 cost basis. If your current tax rate is 28%, that would mean a $28,000 tax bill the year of the distribution, but taxes on the capital gains would be deferred until you sell the shares. Moreover, as long as you hold the shares for more than one year, the actual capital gains (specifically the $300,000 you had when you rolled your 401(k) over, plus any additional gains beyond that) would be taxed at the appropriate capital gains tax rate for your income level, but not until you actually sell the shares. For most folks, that's a 15% tax rate, which could be significantly less than your ordinary income rate.
When it pays off
Rolling company stock with net unrealized appreciation into a taxable account makes sense if it means you'll pay less in total taxes on the income you get from the distributions. Let's say you will pay a 25% tax rate in retirement (since most people's income falls slightly) and you're in the situation described above:
- $28,000 in tax paid on initial distribution before retirement, as described above.
- $300,000 in taxable capital gains.
Let's also -- for the sake of simplicity -- assume the stock price doesn't go up (or down) between the time you roll it into a taxable account and the time you sell it. If you take advantage of the taxable rollover -- meaning you pay regular income tax on your cost basis at the time of the rollover -- and then pay 15% in capital gains taxes on the $300,000 in gains, your total taxes would be $73,000 on $400,000 in income. That's good for an 18.25% tax rate.
If you were to roll over that $400,000 into a regular IRA (or leave it in your 401(k)) and just take distributions directly in retirement, you'd pay regular income tax on distributions, at your regular tax rate. If your tax rate were 25% in retirement, you'd pay $100,000 on that same $400,000 in distributions.
That's $27,000 in taxes that you could have avoided.
Do the math, and consider the risks
It's important to consider a few things beyond just the math if you think net unrealized appreciation could benefit you. First, if you are younger than 60, you could be subject to a 10% penalty for taking an early distribution, and this could change the math significantly. If a large percentage of your wealth is tied to one company's stock, you should also consider the risk that poses to your retirement as well. If that's your situation, you may want to consider rolling over some of the shares to sell and diversify your retirement savings.
Remember, you'll lose the tax-deferred benefits once those shares are removed from a retirement account. This can be a big deal if you're still years away from retirement or plan to sell some of your stock soon, and reinvest into a different investment. In other words, if you're closer to retirement age, it's probably a solid strategy if the numbers make sense. The younger you are, though, the more you'll want to consider the long-term implications of losing the advantages of a tax-deferred account.
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