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 roll over 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 distributed out of the 401(k) upon termination of the company for the price that it was purchased for, also known as its cost basis. This distribution creates income in the amount of the cost basis. 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 1998, 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 a NUA distribution, he can distribute the $200,000 of ABC stock and only pay income tax on the $20,000 cost basis. As long as he holds the ABC stock for more than one year after distribution, the rest of the $180,000 will be taxed at lower long-term capital gains rates. Take a look below:

Taxable 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 and selling it a year later, Mark can lower his tax bill by $16,200.

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 will no longer outweigh the loss of tax deferral that a 401(k) and rollover IRA provide. Simple cost-benefit analysis can determine the amount of years of tax-deferral that make distributing an NUA no longer advantageous compared to leaving the funds in an IRA. 

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 effectuate 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 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.

Lastly, you are not obligated to distribute all of the company stock eligible for NUA treatment. If you have received company stock recently and the stock has actually declined in value, you can exclude that stock. 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.