Leaving an employer (and an associated employer-sponsored 401(k) plan) often leaves clients with any number of questions—not the least of which is what the client should do with the funds that he or she has accumulated in the employer-sponsored 401(k) plan. The reflexive reaction may be to transfer those assets into an IRA maintained by the client in order to preserve tax-deferred treatment in the years before the client retires. Despite this, for some clients, the tax benefits that can be realized by an underutilized strategy involving the net unrealized appreciation (NUA) of employer securities held in tax-deferred accounts can lead to a tax surprise that’s actually pleasant—if the circumstances are optimal.
The NUA Tax Break
Clients whose employer-sponsored 401(k) plan assets consist partially of appreciated employer securities may be eligible to take advantage of the net unrealized appreciation tax break. Net unrealized appreciation (NUA) is the gain on employer stock that has accrued from the time it was acquired within the qualified retirement plan up until the time that the stock is distributed to the client.
The NUA tax strategy allows certain clients whose qualified retirement plans contain these appreciated employer securities to eventually pay taxes on the appreciated value of those securities at the lower long-term capital gains tax rate. The remaining qualified retirement plan assets are taxed at the taxpayer’s ordinary income tax rate under the traditional rule for taxation of plan distributions.
In order for a client to take advantage of the NUA strategy, he or she must be eligible to take a lump sum distribution from the qualified retirement plan in question. This means that the entire value of the account (and all accounts sponsored by the same employer) must be distributed (whether to a taxable account or IRA) within one single tax year, though all distributions need not occur at the same time. The employer securities are taken as shares in the company, and cannot be converted into cash prior to distribution.
In order to be eligible for a lump-sum distribution, the client must have reached age 59½, become disabled or retired (for certain employees), or died. The eligible client transfers the employer securities held in his or her 401(k) into a taxable account, realizing the gain on the sale of the employer securities when those securities are sold, while the remaining assets can be transferred into an IRA.
This strategy has proven effective for some clients. For example, if employer securities within a client’s 401(k) are worth $100,000, but originally cost $20,000, only that $20,000 would be taxed at the client’s ordinary income tax rate. The remaining $80,000 would be taxed at the applicable (lower) long-term capital gains rate.
It is important to note that if the client chooses to roll his or her 401(k) plan assets into an IRA, the NUA tax break will no longer be available even if the assets consist of highly appreciated employer securities that are later sold. Further, if the client is under age 55 when he or she leaves the employer, a 10% penalty tax will apply in addition to the otherwise applicable tax rates.