Clients’ focus has overwhelmingly been drawn to issues surrounding the 2017 tax reform legislation since its enactment more than a year ago. Despite the importance of the sweeping tax overhaul, attention should be drawn back to the potentially valuable retirement income planning strategies available simply by maintaining an employer-sponsored 401(k)—strategies that can be even more valuable in terms of minimizing certain clients’ overall tax liability.
With tax season drawing to a close, clients who are nearing retirement should take stock of the assets held within their 401(k)s while it is still early in the year to determine whether the potentially valuable net unrealized appreciation (NUA) tax minimization strategy might work for them in 2019 or the coming years.
Net Unrealized Appreciation: Basic Mechanics of the Strategy
Net unrealized appreciation (NUA) is the gain on employer stock that has accrued from the time it was acquired within the client’s 401(k) plan up until the time that the stock is distributed to the client. In other words, NUA is the growth of the stock value over and above what the client originally paid for it, which can often be substantial in cases where a client’s employer provided a discount to employees purchasing company stock years ago.
If the client’s 401(k) holds employer stock that has appreciated over the years, the client may be eligible for long-term capital gains tax treatment when the stock is sold, rather than the ordinary income tax treatment that would typically apply to 401(k) distributions. Further, the 3.8 percent net investment income tax that is often added to the long-term capital gains rate for higher income clients is not applied to the NUA, which is treated as a qualified plan distribution. (Note that any gain realized after the original distribution would be subject to the 3.8 percent tax.)
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 401(k) 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. This is why it becomes important for the client to begin evaluating the potential NUA strategy fairly early in the tax year.
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.
Importantly, the employer stock must be segregated from the other 401(k) assets—meaning that the client cannot simply roll all assets into an IRA. Once the employer stock is rolled into an IRA, the potential NUA tax break will be lost.