- As the stock market soars and more older workers retire, those with company stock in their 401(k) may consider a move to reduce future taxes before rolling their balance to an IRA.
- The tactic, known as net unrealized appreciation, or NUA, allows employees to lock in lower tax rates on part of their stock growth.
- However, there are strict rules to qualify and it's not the right step for all investors, financial experts say.
As the market soars and more older workers retire, those sitting on appreciated employer stock in their 401(k) plans may have an opportunity to pay lower taxes on part of that growth.
The strategy, known as net unrealized appreciation, or NUA, allows someone to lock in lower capital gains rates rather than paying income taxes on a portion of employer stock appreciation.
However, the chance to secure NUA disappears when someone rolls employer stock from their 401(k) to an individual retirement account, which is a common mistake, according to financial experts.
"NUA is potentially one of the biggest transactions someone will make in their life and can be one of the costliest if not done correctly," said Adam Wojtkowski, certified financial planner at Smith Salley & Associates in Walpole, Massachusetts.
Moreover, NUA may not be suitable for all investors. Here's what to know before attempting this.
Someone may only leverage NUA by taking a lump-sum distribution, meaning they empty their 401(k) within a single tax year. The transfer must happen after a "triggering event," such as the account owner's death, disability, leaving a job after 55 or turning 59½.
"The biggest mistake is not completing the transaction all in one calendar year," said Brian Schmehil, CFP and director of wealth management at The Mather Group in Chicago.
For example, let's say someone is retiring with company stock in their 401(k) worth $300,000, and the value was $100,000 when their employer made the contribution.
If they are in the 32% tax bracket, they will owe $32,000 in income taxes on the $100,000 when transferring the stock from their 401(k) to a brokerage account.
However, they will pay long-term capital gains on the NUA worth $200,000, which is the stock's value on the date of the distribution ($300,000) minus what their employer contributed ($100,000).
Any growth after that would be short-term or long-term capital gains, depending on how long they wait to sell the stock.
If they have additional non-employer stock in their 401(k), they may roll the remaining balance into an IRA and they will pay ordinary income taxes upon distribution.
Although NUA may offer significant tax savings, investors need to weigh the pros and cons before making any moves, financial experts say.
NUA may not pay off without sufficient stock growth before the transfer. There's also a risk of continuing to hold large amounts of employer stock in retirement, said Schmehil.
"The tax benefits could completely go away if that stock doesn't perform well," he said.
Investors also need a plan for paying income taxes in the year of the transfer, Wojtkowski said.
For example, someone may complete the rollover at the end of the year and then sell shares at the beginning of the following year to cover the tax bill.
Moreover, investors must track their NUA after the transfer to ensure it receives proper tax treatment when they sell, Schmehil added.
While it may be tempting for someone to decide on their own, experts agree it's critical to weigh the consequences with a financial advisor or tax professional with NUA expertise.
"It's nearly impossible for the average investor retiree to make the right decision," Schmehil added.