Do you work for a large, publicly-traded company that gives you company stock in your 401(k) as a form of compensation? There is a great opportunity to distribute your company stock in a tax-efficient way. Many companies use employee stock ownership programs or other forms of compensation tied directly to the performance of the company’s stock in order to incentivize better performance.

The stock may be accruing substantial value in your 401(k) and is likely the most volatile part of your account. Don’t sell it or rollover your 401(k) to an IRA without considering whether you will benefit from net unrealized appreciation (NUA).

What is NUA?

NUA is a specific tax code provision for employer stock held inside of a 401(k). This stock can be taken out of the 401(k) when you leave the company for the price that it was purchased for, also known as its cost basis. Only company stock gets this treatment. This distribution does create income in the amount of the cost basis but can result in paying a lot less in tax over your lifetime. Let’s take a look at an example:

Mark has been working at ABC, Inc for 20 years. Each year, ABC has given him $1,000 worth of ABC stock into his 401(k) as a compensation incentive. Since ABC has grown substantially since 2000, the stock that Mark owns is now worth $200,000 inside of his account. Mark is 60 years old and is ready to retire. By utilizing an NUA distribution, he can distribute the $200,000 of ABC stock and has to immediately pay ordinary income tax on $20,000 of the income (or the cost basis). What about the other $180,000? That qualifies immediately for long-term capital gains rates. This means he could sell the $200,000 of ABC stock and pay the following: 

 w/ NUARegular Dist
Distribution$200,000$200,000
Ordinary Income at Distribution$20,000$200,000
Ordinary Tax at 24%$4,800$48,000
Capital Gains at 15%$27,000$0
Total Tax$31,800$48,000

By distributing the stock with an NUA, Mark can lower his lifetime tax bill by $16,200. 

There is a tradeoff here. By distributing the stock from the 401(k) plan – the value of that stock will no longer qualify for tax-free growth like it would have inside of a 401(k) or a Rollover IRA. Instead, the proceeds from that stock are held inside a brokerage account where dividends and realized capital gains are taxed annually.  This difference in taxation creates a breakeven point where the NUA will no longer be a net benefit to you. This breakeven is usually calculated in years. 

The benefits of the NUA distribution decrease as the basis of the stock gets closer to the actual market value. Using the example above, Mark’s basis in his stock was only 10% of the value stock. If the basis was $180,000 and the stock was currently worth $200,000, then the benefits of the NUA likely no longer outweigh the loss of tax deferral that a 401(k) and rollover IRA provide. Cost-benefit analysis can determine which strategy is advantageous but a general rule of thumb is that the cost basis should be less than 50% of the current value. 

Other considerations

Distributions are still subject to the 10% early distribution penalty if taken before age 55. However, the penalty amount is 10% on the lower cost basis and not on the total value of the distribution. This means that a separation of service before age 55 could still provide for a favorable NUA distribution.

NUAs can still be achieved at age 59 ½ if you separate from service before then. There are a few triggering events that make NUA’s possible. The main three are:

  • Separation from service
  • 59 ½
  • Death

You are able to start an NUA as long as the entire 401(k) balance remains inside the employer-sponsored account during the passing of either of those three events. 

Large positions in company stock are generally not advisable. A quick rule of thumb is that you should never have more than 10% of your net worth in any one asset. Putting too much of your 401(k) into your company stock is risky. The stock will do poorly if the company does poorly. You are also more likely to be laid off if the company does poorly, which compounds the downside risk. Don’t intentionally stack your 401(k) with company stock to do an NUA. 

Lastly, NUA treatment isn’t all or nothing. If you have received company stock recently and the stock has actually declined in value, you can exclude that stock. However, you need to have records to show what you bought each share of the company for and sometimes your 401(k) provider doesn’t have the information readily available. It is generally wise to only include stock with a substantial gain which likely won’t include stock within the past 5 years.

NUAs are not right for everyone. They require an intensive amount of planning and the trade-off is paying the tax bill up-front instead of possibly deferring it for many years. Reach out to us to schedule a time to chat if you have a large amount of employer stock in your 401(k) and you want to know the best plan of action for it.

Written by Garrett Gould

Garrett Gould is a financial planner who specializes in long-term tax management and creating ideas that will help you reach your definition of financial independence. He is the primary point of contact for clients and helps earlier retirees figure out a way to make retirement happen. Garrett is a CFA charterholder and an Enrolled Agent with the IRS.