Source: Adobe Stock

When clients leave a job or retire, the usual advice you might give them regarding their 401(k) account is to roll it over to an IRA. This is generally a sound approach. However, when their 401(k) includes shares of their employer’s stock, a tactic called net unrealized appreciation (NUA) might be a better approach for this stock.

What is NUA?

NUA is a technique contained in the tax code allowing company stock held inside of a 401(k) plan to be rolled into a taxable account instead of into an IRA account. The value of the stock is taxed, but it is taxed at its cost basis, not at the current market value of the stock. Any additional investments in the account, such as mutual funds and other investments, can still be rolled into an IRA account to preserve the tax-deferred nature of this money. Your clients can get the cost basis of their shares from the company.

If the stock is held for at least a year and then sold, the gains are treated as long-term capital gains and taxed at the preferential long-term capital gains rate. If the stock was rolled over into an IRA, the value of the shares would be taxed as ordinary income when withdrawn upon retirement. In some cases, using NUA can result in significant tax savings for your client.

Key Considerations

David Smith, CIMA® CFP® of Robinson Smith Wealth Advisors, LLC says, “NUA can make a lot of sense if the cost basis on the stock is very low compared to the current price.” 

Smith adds, “For investors with a high percentage of their investment assets in retirement accounts, NUA can help them diversify some of their holdings into taxable accounts. NUA may not make much sense if the difference between the cost basis and value of the stock is small, or if the investor may take a sizeable tax hit on the transaction.” 

Every client’s situation is different, so an analysis of the pros and cons of NUA should be done on a client-by-client basis. 

Key Cautions

Jim Blankenship, CFP®, EA of Blankenship Financial Planning offers two cautions to advisors when using NUA with their clients.

He says, “One hang-up that may cause NUA treatment to be unavailable for the participant is the complete distribution rule. If you don’t complete the entire distribution of the account within a single tax year, NUA treatment is no longer available. The key here is that none of your 401(k) plan money can still be in the account at the end of the tax year.”

Blankenship adds, “Another issue that folks don’t realize about NUA stock: upon the death of the original owner, if there is stock that has been given NUA treatment, this stock does not step-up in basis when inherited. The beneficiary (or the estate) receives the same basis that the original owner of the NUA-treated stock had after the original distribution. This can surprise heirs sometimes, because there are still capital gains to be taxed upon the sale of the NUA-treated stock.”

There is also the risk that the price of the shares might decline after the distribution, which could diminish the value of using the NUA approach. 

For clients to whom NUA treatment of company shares might apply, this technique can save them considerable tax dollars. It is certainly another tool in your toolkit for helping clients faced with retirement account rollover decisions.