Distributions from a traditional 401(k) plan are generally taxable as ordinary income at your regular income tax rates. This includes pre-tax contributions plus earnings. If your traditional 401(k) plan is rolled over to a traditional IRA, the same rule applies when you withdraw funds from your IRA.
Company Stock NUA Exception
There’s an exception to this rule for highly appreciated company stock held in a 401(k) plan. Appreciation is the difference between current value and the cost of the shares when they were put in the plan.
Although you can roll over company stock from your 401(k) plan to an IRA, it generally isn’t advisable to do so if the stock is highly appreciated. This is due to the tax break on net unrealized appreciation (NUA) of company stock.
Under the NUA exception, you can withdraw your highly appreciated stock from your 401(k) plan, transferring it to a taxable brokerage account without the market value of the stock being subject to taxation. The net unrealized appreciation, or NUA, is taxable at favorable federal long-term capital gains tax rates when you sell the stock. Only the original cost of the stock will be subject to regular tax rates in the year of distribution if you meet two tests.
NUA Test #1 – Triggering Event
There are two tests governing when you can apply the NUA exception. Test #1 is that the distribution must occur after any one of the following four triggering events:
- Age 59-1/2
- Separation from service (not for self-employed)
- Disability (only for self-employed)
Once one of the four triggering events occurs, the NUA exception applies in the year of the qualifying event and in any subsequent year subject to compliance with test #2.
NUA Test #2 – Lump-Sum Distribution
After the occurrence of one of the four triggering events, you must take a lump-sum distribution from your 401(k) plan. To qualify as a lump-sum distribution, (a) the distribution must occur in one tax year and (b) your 401(k) balance must be zero by the end of that year.
Let’s assume that Tom works for Tesla, he has a traditional 401(k) plan, and Tesla stock is one of the holdings in Tom’s plan. Let’s further assume that Tom left Tesla last year to go work for a startup (triggering event #2). Tom initiated and completed a lump-sum distribution from his plan in the current year. As part of the process, he transferred 100% of his Tesla stock to a nonretirement brokerage account.
The fair market value of Tom’s Tesla stock on August 12th, the date of distribution, is $1 million. His cost basis is $100,000, resulting in net unrealized appreciation, or NUA, of $900,000. Tom would pay ordinary income tax at his regular tax rates on his cost basis of $100,000 in the year of distribution.
The NUA of $900,000 will be taxed at favorable long-term capital gains tax rates when the stock is sold. This is true even if Tom sells the stock the day after the distribution. Had Tom instead transferred his Tesla stock to a traditional IRA, Tom, and potentially his heirs would be taxed at ordinary tax rates on all distributions from Tom’s IRA.
Let’s suppose that Tom decides to sell his Tesla stock 20 days later on September 1st after it has increased in value to $1.2 million. Tom’s capital gain would be the difference between the current value of $1.2 million and his cost basis of $100,000, or $1.1 million, taxed as follows:
- Long-term capital gain on the NUA of $900,000 taxed at favorable long-term capital gains tax rates
- Short-term capital gain on the additional appreciation of $200,000 since the date of distribution taxed at ordinary income tax rates since the stock was sold less than a year from the date of distribution
Complying with the NUA Exception
As previously stated, there are strict rules governing when you can apply the NUA exception. Failure to comply with the rules will result in ordinary income vs. favorable long-term capital gain tax treatment on the unrealized appreciation of company stock held in a 401(k) plan.
There are ten things to keep in mind to avoid unpleasant surprises, several of which have been addressed in various IRS private letter rulings:
- Do not transfer highly appreciated company stock to an IRA. The NUA tax break will be lost forever if this is done.
- You cannot leave any funds in the company plan. All 401(k) plan funds must be distributed in one tax year.
- If the 401(k) plan consists of employer securities and other assets such as cash and mutual funds, the other assets can and generally should be transferred to an IRA account. This will enable you to zero out your 401(k) balance without current year taxation on the plan’s other assets and receive favorable NUA taxation treatment on the distribution of the highly appreciated company stock. This will occur so long as the transfer of the other assets is completed by the end of the same year that the employer securities are distributed.
- A NUA transaction may take several weeks to complete from the time the employer makes the distribution of stock to the time that the transfer agent issues new shares. It’s a good idea to never start the process after Thanksgiving. It’s better to wait until the beginning of the following year. This will enable you to complete the distribution in one year.
- Don’t sell the company stock in your 401(k) plan too quickly. Once you sell the shares, they’re no longer eligible for the NUA tax break. Keep in mind that most companies aren’t like Enron.
- Confirm that there have been no deemed loan distributions from your 401(k) plan. A deemed distribution occurs when there’s a default on a loan from a plan. If this occurs, the entire outstanding balance of the loan is treated as a taxable distribution and the transaction won’t qualify for favorable NUA taxation.
- Keep track of the cost basis of the company stock in your 401(k) plan. While the basis of company shares isn’t affected, this can be tricky if there are mergers, acquisitions, spin-offs, and corporate reorganizations.
- Make sure that beneficiaries are made aware of your NUA, including the cost basis of your company stock, since death is one of the four NUA triggering events. If you have a 401(k) plan with highly appreciated stock in your plan when you die, your beneficiary(ies) can claim the NUA tax break on a lump-sum distribution. The distribution can be taken in any year after you die so long as it is completed in one tax year. There are other tax rules that come into play in this situation that are beyond the scope of this article.
- Confirm that your employer will first transfer the plan’s other assets directly to the IRA custodian as a trustee-to-trustee transfer and then distribute the NUA shares to you via an in-kind transfer to your nonretirement brokerage account in one tax year, leaving nothing in the account. This will avoid IRS’ mandatory 20% federal income tax withholding requirement on distributions from a qualified plan.
- Be aware that brokerage firms generally don’t assign a special designation to NUA stock on monthly investment and annual tax reporting statements. It’s up to you, your financial advisors, and potentially your beneficiaries to keep track of NUA stock. This is necessary to claim the proper income tax treatment when NUA stock is sold, i.e., allocation of capital gains between short- vs. long-term.
Other NUA Benefits
In addition to favorable long-term capital gains tax treatment on NUA, there are several other benefits that can be realized from engaging in a NUA transaction. These include the following:
- Except for cost basis, highly appreciated stock held in a 401(k) plan won’t be taxable at ordinary income tax rates in the future.
- Today’s current low tax rates can be locked in before rates are likely to increase. This includes ordinary income tax on the cost basis of company stock and long-term capital gains tax rates on NUA.
- The company stock that’s distributed won’t be subject to required minimum distributions, or RMDs.
- There are no limitations on how or when the company stock can be used as there would be if the stock is continued to be held in a 401(k) plan.
- Non-spouse beneficiaries won’t be affected by the repeal of the stretch IRA rules and associated 10-year distribution requirement on the distributed company stock.
- All beneficiaries can use the NUA tax break to the extent that it wasn’t used during the owner’s lifetime.
When Taking Company Stock Isn’t a Good Idea
Taking a distribution of company stock from a 401(k) plan and complying with the NUA rules can result in significant income tax savings and other benefits when the stock is highly appreciated, i.e., its fair market value significantly exceeds its cost basis. Likewise, NUA transactions should be avoided whenever there’s either a high cost basis or the stock isn’t highly appreciated.
Let’s suppose that Tom in our example worked for General Electric instead of Tesla. He began purchasing GE stock in his 401(k) plan in 2000 when the price was $55. With a few exceptions, the price has steadily declined with a current price of $10 per share. The current value of Tom’s stock is $100,000 with a cost basis of $400,000. Tom wouldn’t be a good candidate for a NUA transaction given the unrealized loss of $300,000.
The NUA tax break is a valuable strategy that shouldn’t be overlooked. The income tax savings and other benefits can be substantial in the right situation. It’s important to keep in mind that a NUA transaction can be pursued by your beneficiaries if it isn’t done during your lifetime.
If you have highly appreciated company stock in your 401(k) plan, you and your financial advisors should periodically explore and plan for a NUA transaction as a possibility even if you haven’t experienced one of the four triggering events. This includes being aware of the various triggering events, the lump-sum distribution requirement, and analyzing the various compliance requirements beginning with keeping track of the cost basis of your stock.
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the sole proprietor of Robert Klein, CPA. Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.