Most people are familiar with the idea of saving as much as possible during their working years and investing savings wisely to maximize returns once they retire. But it is just as important to consider tax strategy. After all, if you pay more taxes on your retirement distributions than the law requires, that can cost you precious cash in your golden years.
Ignoring accounts that hold company stock is one way we see people lose money in taxes. Many workers either get company stock as part of their compensation or are able to take advantage of company 401(k) programs that include company stock. In retirement, how you distribute that company stock will play a key role in determining your tax liability for its value.
Usually, any distributions you take from tax-deferred retirement accounts are taxed as ordinary income when you distribute them. If that retirement account includes stocks and those stocks appreciated while you owned them, you’ll pay ordinary income taxes on the stocks’ value at the time of distribution. For large holdings of stocks that increased significantly in value while you held them, the resulting tax bill can be significant.
However, if the stock is in the company you worked for, there’s an opportunity to reduce that tax burden. Through Net Unrealized Appreciation, or NUA, the IRS will only tax the basis — the purchase cost — of company stock at ordinary income rates. Any appreciation in that stock gets taxed at a lower capital gains rate. If you’re fortunate enough to have worked for a company whose stock gained significantly in value over your career, this strategy can save you a lot of money.
For example, you have a 401(k) that holds $500,000 in company stock, but it only cost $100,000 to acquire. Distributing it normally in retirement would result in you paying ordinary income tax on half a million dollars. By applying the NUA strategy, you’d only pay ordinary income tax on $100,000. The remaining $400,000 would be taxed at a friendlier long-term capital gains rate.
The NUA can save you money in another way as well. Pulling NUA stocks out of a retirement account before rolling that account into an IRA means there’s less money in the IRA. Because required minimum distributions are calculated based on a retirement account’s value, having less money in the IRA reduces your RMDs. That automatically lowers your tax bill on those RMDs as well.
The NUA treatment is a powerful tool for the right situation. However, there are a number of factors you need to keep in mind when considering the NUA treatment for your company stocks.
In order to apply NUA treatment to a stock, there must first be a triggering event, such as quitting, retiring or getting fired from your job. Death, disability and turning age 59½ also qualify as triggering events.
Tax-Deferred Accounts Only
Once the triggering event happens, you need to follow the rules to ensure the stock is eligible for NUA. The stock must be in a tax-deferred retirement account. Accounts like Roth IRAs and other tax-exempt vehicles don’t qualify. If the stock is held by a mutual fund account, the fund must only hold company stock or cash. Stock from other companies disqualifies the fund. You can still diversify your 401(k) and invest in other funds within it while working. The fund you intend to apply NUA treatment to must consist of only company stock or cash.
If you want to take advantage of NUA tax opportunities, you need to distribute the entire retirement account in the year of the NUA, but there’s a pitfall to avoid here too. It’s common to roll retirement accounts into IRAs to distribute them. But doing so with an account that contains company stock will render it ineligible for NUA treatment.
To preserve eligibility, you need to take the company stock out of the retirement account and put it in a brokerage account. Then you can roll the rest of the account into an IRA.
Is This the Right Strategy for You?
You might think, at this point, that whenever you have NUA-eligible assets, you should always take advantage of that opportunity. But there are scenarios where it doesn’t make sense to do so. For instance, if your basis is high relative to its current value, it’s possible that you’d come out ahead by simply rolling the entire account into an IRA.
In such scenarios, it’s wise to compare predicted outcomes of keeping it in a tax-deferred account as long as possible versus distributing it now and applying the NUA strategy. But forecasting those outcomes is no small task and probably not one you want to perform yourself.
There are a lot of nuances in dealing with retirement account distributions. It’s important to work with a financial planner to make sure you take the right steps. Financial planners can work to predict the most likely spectrum of future tax rates at distribution time for your accounts. And they can make sure distributions are handled properly, so company stocks don’t lose NUA eligibility through missteps. Working with a financial adviser to handle your investment accounts can help put you on a path to maximizing your assets in retirement.
The appearances in Kiplinger were obtained through a PR program. The columnist received assistance from a public relations firm in preparing this piece for submission to Kiplinger.com. Kiplinger was not compensated in any way.
As Principal and Director of Financial Planning, Sam Gaeta helps clients identify financial goals and make plan recommendations using the five domains of financial planning -- Cash Flow, Investments, Insurance, Taxes and Estate Planning. He is responsible for prioritizing clients' financial objectives and effectively implementing their investment plans and actively monitors the ever-changing nature of clients' financial and investment plans.
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