Utilizing the Net Unrealized Appreciation Strategy for Tax Savings
We all know the benefits of saving for retirement with a 401(k) account: immediate tax deductions against your W2 income and tax-deferred growth within the account until you start taking distributions.
We also know, usually to our cost, that distributions from a 401(k) or from Rollover IRAs are taxable as ordinary income at the taxpayer’s highest marginal tax rate in the year of the distribution. So, if you are in the 32% tax bracket, you will only actually see $68 after taxes for every $100 distributed from your 401(k) or Rollover IRA account. That's quite a hit, and it could be even higher if you are in the 37% marginal tax bracket.
Alternatively, imagine the benefit of being able to treat your retirement distributions as if they were capital gains and not as ordinary income taxable at your marginal rate. Instead, you would be paying tax at the long-term capital gains rates of 15% or 20%. Factor in the additional benefit that this may be available to you over multiple years as you spend down your retirement accounts, and you could be looking at very significant tax savings.
For some 401(k) accounts, it is possible to get capital gains tax treatment as you distribute these assets. This is known as a Net Unrealized Appreciation (NUA) Strategy.
Key Requirements for an NUA Strategy
- The first thing to know about an NUA strategy is that it is only available in some 401(k) accounts – namely those 401(k) balances that contain significant value in the employer stock. There is no minimum required value (and no maximum), but at approximately $50K and over in current market value for the employer stock, it justifies taking a closer look.
- The second major requirement for a successful NUA strategy is that the cost basis of the employer stock must be low relative to the current market value of the stock. How low does it need to be? A good rule of thumb would be 30% (or lower) of the current market value. In this regard, it is possible to cherry-pick only the low-cost basis employer stock for the NUA strategy and disregard the high-cost basis employer stock. This low-cost basis condition is relevant because the cost basis of the employer stock selected for the NUA strategy will be regarded as immediately taxable as part of the strategy.
NUA Strategy Example
Erik is 65 and has a 401(k) with Fair Market Value of $6M.
- Among the securities in Erik’s 401(k) are $2.9M worth of Erik’s employer, BigOil Inc.
- The share price of BigOil Inc. is currently $100 per share.
- Erik has a total cost basis of $500K in the stock.
As Erik has recently retired, he has the choice of either:
A) Rolling over his entire 401(k) into a rollover IRA or
B) Doing a rollover on some of the 401(k) and sending a portion of the employer stock within the 401(k) account to a taxable NUA account where any subsequent disposals from the NUA would be taxable at long-term capital gains tax rates.
The drawback with deploying an NUA account is that Erik must pay tax at ordinary income tax rates on any cost basis of his employer stock that he sends to the NUA account as part of the overall 401(k) rollover.
Focusing on this downside, let’s say on a $500K of cost basis, Erik will pay $140K in taxes (at a blended 24% and 32% tax bracket). This is an immediate tax cost that Erik would not have suffered had he instead simply rolled his entire 401(k) account into a traditional IRA and not deployed the NUA strategy at all.
This is the major drawback of the NUA strategy: taxation of the cost basis of the NUA shares.
But the NUA strategy also has a major benefit: taxation at long-term capital gains rates when those NUA shares are eventually sold from the taxable account.
Focusing on the benefit side of the equation, the taxable NUA account now has $2.9M of BigOil Inc. stock with a cost basis of $500K. This gives Erik the potential to realize the $2.4M in unrealized appreciation at a 15% tax rate as opposed to a 32% tax rate if he were not to do the NUA strategy and take the $2.9M as regular IRA distributions or RMDs via a rollover IRA.
The tax saving between the NUA strategy and the IRA rollover is a whopping $428K: $360K + $140K with the NUA strategy vs. $928K with no NUA and a straight rollover IRA.
And the benefit of the NUA could be even larger if the stock of BigOil Inc. continued to appreciate above $100 per share and Erik was able to leave some of the NUA account to accumulate without selling the employer stock.
Time Value of Money
A key input when considering the benefits of an NUA strategy is the time value of money. The NUA does involve paying taxes today to access the lower capital gains tax rates on realizations. This needs to be weighed against the benefit of deferring money in a rollover account many years in the future but at potentially higher tax rates on IRA distributions.
Other factors that will determine whether you should utilize the NUA strategy or not are:
- The expected marginal tax rates in retirement
- The taxpayer’s age
- The amount of cash-flow, if any, needed to be taken from the retirement pot to fund living expenses.
View a client example described by Glen Rives, JD, CFP®, Wealth Advisor, Director
An NUA strategy could be right for your 401(k) rollover if you have a large amount of employer stock within your 401(k). Contact BakerAvenue to help you navigate the rules and help you analyze your options.