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.

Internal Revenue Code Restrictions

The IRC lays out extremely specific requirements that the client must satisfy in order to take advantage of the NUA strategy and receive favorable long-term capital gains tax treatment.

Although every dollar that the client holds in qualified plans maintained by the same employer must be withdrawn from the account, the employer stock must be distributed to the client “in kind” in order to retain eligibility for long-term capital gains treatment.  This means that the stock cannot first be converted to cash and distributed to the employee.

Further, the fact that every dollar must be withdrawn from the clients’ accounts sponsored by the employer means that the NUA strategy may be complicated if the client continues to work for the employer unless caution is taken to ensure that no funds are transferred into the 401(k) late in the year.

The NUA strategy becomes most valuable if the employer stock has appreciated substantially since it was purchased within the 401(k). Further, if the basis of the stock is high compared to the amount by which the stock has appreciated, the strategy may be less valuable (though the client is permitted to apply the NUA strategy to only a portion of the securities received in the lump sum distribution).

Further, the length of time that the client plans to allow the assets to grow in the IRA is important—for longer time periods, the tax-deferred growth potential offered by the IRA may be more valuable than the NUA tax break.  This means that the NUA strategy may be most valuable for clients who have already retired, or will retire soon, and intend to draw upon the assets transferred into the IRA for living expenses.

Conclusion

The NUA tax break will only be valuable to clients facing a very specific set of circumstances—those who have purchased employer stock within a 401(k) and are now eligible for a lump sum distribution from that account.  For those clients who do meet these requirements, however, the tax savings can be valuable if the specific IRC requirements are satisfied.