Want in on a Well-Kept Secret with Big Tax Benefits? Think NUA.

If you're getting ready to retire and you own a lot of your employer's stock in your 401(k), before you go the usual route and roll your entire nest egg into an IRA, there's a tax strategy you may want to consider.

Net Unrealized Appreciation (NUA) is a tax strategy that many are not familiar with or simply ignore that is especially useful for those with highly appreciated company stock in their employer-sponsored plans. It allows you to pay the long-term capital gains tax rate on part of your stock related savings, rather than paying your ordinary tax rate on all of it. That's where the tax break comes in. For most investors, long-term capital gains rates tend to be lower than their effective tax rate, which can vary.

Why you might want to go the NUA way

How does the NUA strategy work? Well, the IRS allows you to transfer company stock from your 401(k) in-kind, meaning without liquidating it, into a taxable non-retirement brokerage account. You'd immediately pay taxes on the basis amount of the shares — which is what you paid for them — at your ordinary income rate. The growth on the stock, aka the net unrealized appreciation, wouldn't be taxed at all until you sell the shares.

When you finally do decide to sell, the tax rate you'd pay on the NUA would be only your long-term capital gains rate. Those rates currently top out at 20% — compared with ordinary tax rates, which top out at 37%.

On the other hand, if you had rolled the stock to an IRA, the IRS would tax all subsequent distributions from the IRA as ordinary income, regardless of the NUA of the stock. So, that's why it’s better to transfer highly appreciated company stock to a non­qualified brokerage account, rather than rolling the stock over into a tax-deferred IRA: It lets you pay a lower tax rate on the stock's appreciation.

Here's an example of how it works

Let's say you work for a publicly traded company that has a stock-option purchase plan allowing you to purchase shares of the company for a discount. You purchase 1,000 shares at $10 a share ($10,000) and it sits inside your 401(k).

Let's say that the stock is worth $100,000 when you get ready to retire. If you roll that account over to an IRA, that money is going to be 100% taxable at your ordinary income tax rate when it comes out. However, if you use the NUA strategy, you get a significant tax break. You can transfer all those shares to a non-qualified brokerage account — non­IRA, non 401(k) — and the only tax liability you will have is ordinary income tax on the $10,000, which is the cost basis of that stock you originally purchased. If you're younger than 59½, you'll pay an extra 10% penalty on the $10,000 cost basis.

But the appreciation of $90,000? You're not going to pay any income tax on the transfer of those NUA shares into a non-qualified brokerage account from the 401(k).

This is where the sweet spot comes in. Once the shares are in the non-qualified account, you can start to sell off the stock and take the money from the sale out at capital gains rates, which in some cases may be dramatically lower than the owner's ordinary income tax rate. For tax year 2019 the capital gains tax rates were either 0%, 15% or 20% for long-term assets — those held for more than a year. However, under IRS notice 98-24, the gain on the NUA is taxed at the lower long-term capital gains rates, even if the stock is sold the day after the distribution from the 401(k.) Additionally, the realized capital gains from NUA stock do not add toward the income calculation used for the Medicare Surtax of 3.8%.

Regarding that $90,000 that got moved over with no income tax liability: Although selling the appreciated stock can be subject to capital gains taxes, the favorable twist is this: If you're a married couple filing a joint tax return and have taxable income (including any capital gains) under $78,750, then under the current tax law you're not going to pay any capital gains tax on stock that is sold. So, you basically were able to withdraw some money from your 401(k) tax-free using the NUA strategy. And you can do this before age 59½ without penalty on the NUA appreciation.

Penalties, other rules to consider

Different 401(k) plans differ on their distribution rules, so check with the custodian of your 401(k) to see when you may qualify for this type of distribution. If you do this before age 59½, be aware there could be a 10% penalty from the IRS only on the cost basis of the shares that came out. The IRS Rule of 55 may except you from a 10% early penalty if were laid off, fired or retired from your job at age 55 or later. Speak with a qualified tax consultant prior to exercising this strategy.

You need to follow some rules to be able to take advantage of the NUA strategy:

• You can use it only with the stock originally purchased in the employer sponsored plan.
• Also, the NUA is applicable only to company stock.
• The NUA technique is only available upon the complete distribution of the employer-sponsored account. You don't have to transfer all your company stock (you can roll over a portion of your shares to an IRA and apply NUA to the rest), but the entire retirement account must be cleared out.

One downside of NUA stocks in a non-retirement brokerage account is that the shares are not eligible for a step-up in basis at the death of the original owner. In most cases, the beneficiaries of a non-retirement brokerage account can receive a step-up in basis on shares they inherit. When they sell the securities, they realize the gains or losses from the date of the step-up, not the original owner’s date of purchase. Because NUA stocks are not eligible for a step-up in basis, it’s important to have a plan to unwind the position along with having a conversation with your estate planner or attorney.

The bottom line on NUA

Very few advisers know how to implement the NUA strategy. It just comes down to thorough planning, and for many nearing retirement, it's worth a look. Be aware, if you roll over your shares into an IRA from a 401(k), you cannot go back and unwind your decision. So, become informed of these and other tax breaks to keep more of your hard-earned money in your pocket.

Dan Dunkin contributed to this article.