- Did you recently retire? Did you just leave an employer with company stock in your 401(k) plan? Don’t automatically roll your old plan over into your new 401(k) or IRA.
- Consider utilizing Net Unrealized Appreciation (NUA), a little-known strategy that could allow you to be taxed only on the cost basis of those shares—not on the appreciation.
- Many long-time employees are highly vulnerable to concentration risk. You need to diversify, especially in retirement.
- There are three important requirements needed to qualify for the NUA rule.
It’s great that you are loyal to your employer and remain confident in its long-term prospects. Just know that there are some risks associated with having the lion’s share of your retirement savings concentrated in the stock of just one holding.
While it’s not as common as it used to be, millions of employees and retirees still hold large concentrated positions of company stock in their 401(k)s. If you recently retired or separated from an employer that allowed you to accumulate company stock in your 401(k) plan, don’t immediately roll your old plan over into your new 401(k) plan or IRA. Consider the possibility of utilizing a strategy known as Net Unrealized Appreciation (NUA), which may be very tax advantageous for your situation.
In a nutshell, NUA allows you to transfer the company stock held in your 401(k) plan into a taxable brokerage account, in a tax-advantaged manner. When you make the transfer, you pay only ordinary income tax on the cost basis of the shares, not on the appreciation. Normally, the entire distribution from a 401(k) would be taxed as ordinary income, currently 37 percent at the highest marginal federal tax rate. Wouldn’t you rather pay the lower capital gains rate of 23.8 percent on that transfer?
Real World Example
Let’s say you have $1 million worth of company stock in your 401(k) and those shares have an average cost basis of $100,000. By using NUA, you can distribute those shares into a taxable brokerage account and incur only $100,000 of taxable income. The remaining $900,000 of growth in those shares is now subject to the long-term capital gains rate, a lower rate than the ordinary income rate for most people. You only pay the capital gains tax when you sell those shares. Even if you sold all your shares on the same day, you would end up paying less in taxes than if you had cashed out the full $1 million from your 401(k).
Unfortunately, there is no rule of thumb on how to use NUA. Each investor/retiree has unique needs that must be carefully assessed by a CPA and financial advisor.
Here are some important considerations:
- Diversification – When a large concentration stock position is held in your tax-advantaged 401(k) or IRA, diversifying out of that position creates a very small amount of transaction costs and no taxes are created. But when you diversify your position outside of a tax-advantaged account, the capital gains tax kicks in. How much of your portfolio’s overall allocation does this concentrated stock position account for? No more than 10 percent of your portfolio should be held in any one stock. For more information about concentrated stock, review Soundmark Wealth Principal Todd Flynn’s article about Single Stock Concentration Risk.
- Current tax situation – If you have just retired and have not begun taking distributions from your retirement accounts or Social Security, NUA may be a great option. Since you still need money to live on, NUA is an efficient way to diversify away from your concentrated position. If you do not have significant gains in the position and are in a high tax bracket, then it is probably best to diversify away from the position within the 401(k) plan or to roll over the balance into your IRA.
Three important requirements for meeting the NUA rules:
- Must be a lump sum. Your entire account balance must be distributed in the same calendar year. You can’t simply roll over your stock.
- Must be done in-kind. You must transfer shares, not cash.
- Must be done after a triggering event such as death, disability, separation from service, or reaching age 59 ½.
Looking for NUA Advice?
We have encountered many NUA opportunities for clients who hold employee shares of Microsoft, Boeing, and Amazon stock. But NUA can work for those holding shares of many other companies. Let’s connect – we would be happy to help you or someone close to you review your unique situation.
James Nevers, CFP® is an Advisor at Soundmark Wealth Management, LLC. James works closely with physicians, business owners, Directors and Executives at Amazon, Microsoft, and Boeing, and other high-net-worth individuals to help them define their financial goals and implement an ongoing financial planning process.