Will you end up paying too much in ordinary income taxes for company stock in your 401(k) plan?
As a seasoned employee with a diverse array of financial commitments, Net Unrealized Appreciation (NUA) within your 401(k) and Employee Stock Ownership Plan (ESOP) offers a pathway to significant tax savings and aligns perfectly with your multifaceted financial goals. Whether your objectives include paying off a mortgage, funding a college education or preparing for significant family events, understanding and utilizing NUA can greatly enhance your financial strategy, providing immediate and long-term benefits.
Fortune Financial’s specialized approach to managing NUA is an indispensable tool for informed investors. With our deep expertise and qualifications in NUA strategies, our experts are adept at navigating the complexities of tax-efficient retirement planning. Explore the Fortune Financial advantage in transforming how you manage your retirement assets and bringing you closer to achieving your financial dreams.
Unpacking NUA for Enhanced Retirement Planning
In simple terms, NUA is the increase in employer stock value held in a qualified retirement plan. The retirement plans that can include company stock are 401(k), profit-sharing plans, stock bonuses and ESOP plans. The NUA is calculated by taking the cost basis of the employer stock in the plan and subtracting the amount from the stock’s fair market value at the time of distribution. This appreciation becomes critical when considering tax implications upon withdrawal.
Let’s say you purchased company stock for $100 within your retirement plan at the beginning of the year, and it is now worth $120. Your current NUA is $20, which is simply the difference between the current value of $120 and the purchase price of $100, which is the cost basis. The NUA is calculated when the employer’s stock is distributed from the plan as part of the lump sum distribution.
The entire amount is typically taxed as ordinary income when you withdraw funds from a traditional 401(k) or ESOP. However, if a significant portion of your plan consists of employer stock that has appreciated, using the NUA strategy can offer substantial tax benefits. Instead of paying higher ordinary income tax rates on the entire withdrawal, you can pay lower long-term capital gains tax rates on the appreciated portion of the stock when sold. This distinction can lead to considerable tax savings, especially for those in higher tax brackets.
The Center for Retirement Research at Boston College authored a paper detailing how much retirees will pay on their retirement income. “For the lowest four quintiles, taxes are negligible – ranging from 0 percent to 1.9 percent. In contrast, the average liability is 3 percent for the top quintile, 16.4 percent for the top 5 percent and 22.7 percent for the top 1 percent.”
The NUA Process – A Path to Tax Efficiency
Based on the United States Federal Reserve Economic Well-Being of U.S. Households in 2022 survey, “While most non-retired adults had some type of retirement savings, only 31 percent of non-retirees thought their retirement saving was on track, down from 40 percent in 2021. The share of non-retirees who thought their retirement saving was on track was also below the shares who thought their saving was on track in 2017 through 2020.”
The Federal Reserve’s findings underscore the importance of proactive retirement planning, and for those with retirement savings, strategies like Net Unrealized Appreciation (NUA) become even more crucial. By understanding and leveraging NUA, individuals can take these steps to improve the tax efficiency of their retirement savings, potentially helping to bring their retirement planning back on track and align with their financial goals.
Steps to Improve Tax Efficiency
- Qualifying Events for NUA: This could be separation from your employer, whether through retirement, resignation or termination; the occurrence of a disability as defined by your plan; or reaching 59.5 years old. These events trigger the possibility of utilizing the NUA strategy for the company stock in your plan.
- Distribution of Employer Stock: The next step is distributing your employer stock from your 401(k) plan as a lump-sum in-kind transfer directly to a taxable brokerage account, not as a cash distribution. This move sets the stage for the NUA tax benefits to come into effect.
- Roll Over the Remaining Funds: After the employer stock has been moved to a brokerage account, the next step is to roll over the remaining funds—those not consisting of employer stock—into an individual retirement account (IRA). This rollover continues the tax-deferred status of these funds and separates them from the NUA strategy being applied to the employer stock.
- In-kind Transfer to Cover Cost Basis: Within 60 days of the lump-sum distribution, you must initiate an in-kind transfer of the company stock equal to the cost basis from the brokerage account to your IRA. This specific action activates the NUA strategy, ensuring that only the cost-basis portion of your stock is subject to ordinary income tax.
- Capital Gains Tax Advantages: The final benefit of the NUA process is enjoyed when you decide to sell your company stock from the brokerage account. At this point, the sale is subject to long-term capital gains tax rates, typically lower than ordinary income tax rates. This favorable tax treatment applies only to the stock’s appreciation above the cost basis, not to the cost basis itself.
Optimizing Your 401(k) with Strategic Use of Net Unrealized Appreciation
For instance, let’s say you have a 401(k) with a balance of $1,000,000, and it includes company stock; there’s a tax-savvy strategy you might consider to protect your wealth from higher taxes. Here’s how it works:
- Distribute AAPL to Brokerage: The first step involves distributing half of the 401(k) balance, specifically $500,000 worth of AAPL stock, to a brokerage account.
- Rollover Non-stock to IRA: The second step is to roll over the remaining $500,000 in a target date fund or non-employer stock into an IRA.
- Transfer In-kind Cost-Basis Shares to IRA: The third and final step is to transfer $100,000 of AAPL stock, representing the cost basis, from the brokerage to the IRA. This step must be completed within 60 days. If this is not done in the specified time, the strategy is not applicable.
The beauty of this strategy is that it potentially reduces the taxes owed by leveraging the lower long-term capital gains tax rates. Plus, it gives you the chance to diversify your investments. Did that $100,000 of AAPL stock move to your IRA? It can now be spread out across different investments within the IRA without immediate tax implications.
Remember that everyone’s tax situation is unique, and the steps outlined above are based on a hypothetical scenario. The approach should be tailored to your financial goals and tax status, so it’s wise to chat with a financial expert when considering this strategy for your retirement savings.
Implementing NUA for Long-Term Financial Goals
According to Fidelity Investments, “We estimate that saving 10x (times) your preretirement income by age 67, together with other steps, should help ensure that you have enough income to maintain your current lifestyle in retirement. That 10x goal may seem ambitious. But you have many years to get there. To help you stay on track, we suggest these age-based milestones: Aim to save at least 1x your income by age 30, 3x by 40, 6x by 50 and 8x by 60.”
Fidelity Investments sets a clear savings trajectory to maintain your lifestyle into retirement, and reaching these milestones can be more attainable with strategic tax planning. Implementing the Net Unrealized Appreciation (NUA) strategy with a professional firm like Fortune Financial is a key step in this process, offering a sophisticated approach that complements these age-based savings goals and contributes to a robust, comprehensive retirement plan.
Steps for Adopting the NUA Strategy with Fortune Financial
- Initial Consultation: The process begins with a detailed consultation to understand the client’s financial situation, retirement goals and existing investment portfolio, including 401(k) and ESOP holdings.
- Analysis of Financial Position: Fortune Financial experts conduct a thorough analysis of the client’s current financial status, focusing on their 401(k) and ESOP, to evaluate the feasibility and potential benefits of the NUA strategy.
- Tax Considerations and Projections: We then assess the client’s current and projected tax situation to understand the implications of implementing NUA.
- Strategy Formulation: This strategy considers the optimal timing for stock distribution, the tax implications of such moves and the reinvestment of proceeds for diversification.
- Implementation: With the strategy in place, Fortune Financial guides the client through implementing NUA, including managing the distribution of employer stock and overseeing the tax-reporting requirements.
- Ongoing Review and Adjustment: The strategy is not static; it is regularly reviewed and adjusted as needed to align with changing market conditions, tax laws and the client’s evolving financial goals.
Integration into Comprehensive Financial Planning
NUA is not a standalone tactic but a component of a broader financial strategy. Fortune Financial’s certified financial planners integrate NUA into the client’s overall retirement plan. This integration ensures it complements other aspects of their financial life. This holistic approach includes:
Retirement Income Planning:
Some public corporations with 401(k) profit-sharing components establish a separate employee account. The 401(k) represents the employee contributions and the company match. Whereas the profit-sharing portion represents the amount contributed solely by the employer. Both plans may include employer securities and have different cost basis amounts based on various contribution dates.
At first glance, the total cost basis might appear too large and close to the current market value of the shares for an effective NUA election. To determine if this is the case, we have developed analytical software to calculate the portion of employer securities that make the most financial sense for an NUA election. Then, we strategize with clients on how to proceed.
Risk Management: Risk Management is a critical component of financial planning when it involves a significant position in employer stock within a client’s portfolio. Holding a large amount of employer stock can amplify risk due to a lack of diversification if the company’s stock suffers. Lack of diversification can disproportionately affect the individual’s investment portfolio and retirement plans.
Effective risk management involves evaluating this concentration risk in the context of the client’s total investment portfolio, financial goals and risk tolerance. Balance the potential rewards from the employer’s stock performance with the overall need for a diversified portfolio that can withstand market volatility and align with the client’s long-term financial objectives.
Estate Planning: One benefit of most brokerage accounts is the stepped-up basis beneficiaries receive upon the account holder’s death. This means that with the appreciation in the value of an investment over the original purchase price, the beneficiaries’ new cost basis would be the market value or stepped-up basis on the date of death of the account holder and not the original purchase price.
Let’s say your aunt purchased 1000 shares of Microsoft stocks in 1986 for $21 per share for a total cost basis of $21,000. Your Aunt passed away on April 14th of this year when the share price of Microsoft closed at $314.97. By factoring in the nine stock splits since 1986, that 1000 shares would have grown to 288,000. The market value on the date of death would have been $90,711,360. Not factoring in any state taxes on the Microsoft shares, you, as the beneficiary, would now have a stepped-up cost basis of $314.97 per share.
However, in the case of an NUA election, beneficiaries are not entitled to the stepped-up cost basis. The cost basis on the date of death would not be transferred to the beneficiaries; only the original cost would be transferred. In the case of an employer security that appreciates considerably in price over the years, this might result in larger tax issues for beneficiaries who sell the securities after the account holder’s death.
We plan for these scenarios with all of our clients when considering an NUA election. It’s one of the many factors we weigh when determining an NUA strategy with clients.
Tax Planning: Aligning NUA with other tax planning strategies to minimize the client’s overall tax liability during retirement.
At Fortune Financial, we have a strong history of identifying investment opportunities that build wealth for our clients. Watch the video series that I made to learn more about NUAs and how they could enhance your retirement assets.
Act now if you feel like your retirement savings could be better optimized. Reach out to a Fortune Financial advisor to discuss how NUA could enhance your retirement outlook and put you on a path toward a more secure financial future. Don’t wait — take control of your retirement strategy today.
Important Note
This material is provided for educational purposes only and does not constitute investment advice. The information contained herein is based on current tax laws, which may change in the future. Fortune Financial Advisors cannot be held responsible for any direct or incidental loss resulting from applying any of the information provided in this publication or from any other source mentioned. The information provided in these materials does not constitute any legal, tax or accounting advice. Please consult with a qualified professional for this type of advice. The information provided above is obtained from publicly available sources and is reliable. However, no representation or warranty is made as to its accuracy or completeness.
