Avoid Income Taxes with the Net Unrealized Appreciation (NUA) Strategy When Taking Company Stock From Your 401(k)
Does this describe you? You’re approaching retirement or newly retired, and you plan to transfer your 401(k) balance into an IRA. Included in your 401(k) is a significant amount of company stock that has appreciated in value over the years. Before you make that transfer, first consider a tax-saving strategy that may benefit you.
This strategy allows you to apply capital gains tax rates to the net unrealized appreciation (NUA) on company stock after it is distributed from your 401(k). NUA refers to the increase in value of employer stock held within a 401(k), or other employer-sponsored retirement plan. NUA is the difference between the stock's initial purchase price (cost basis) and the stock’s value when it is distributed to the employee.
If you transfer your company stock from the 401(k) directly into an IRA, the tax treatment is different. If you sell the company stock inside the IRA and withdraw the proceeds , the entire amount of the sale proceeds will be taxed as ordinary income.
To take advantage of the tax saving NUA strategy, you must withdraw the company stock as part of a lump-sum distribution from your 401(k) after a triggering event. A “triggering event” includes retirement, separation from service, reaching age 59½, death (for beneficiaries), or disability. The entire 401(k) account balance must be withdrawn — you can’t remove just the company stock.
How it works:
When you take a lump-sum 401(k) distribution, you make sure to receive the company stock “in kind” and pay ordinary income tax on the cost basis portion of the stock value in the year of the distribution.
You make a timely rollover IRA contribution of the remaining non-company stock portion of the 401(k) distribution to avoid paying income taxes on it.
When you later sell the company stock, you only pay long-term capital gains tax on the NUA. The cost basis portion of the stock is not taxed again upon sale.
Key points to remember:
The NUA strategy will not work if you sell the company stock while it is in your 401(k), or transfer the stock into your IRA;
The shares of company stock must be distributed to you as part of a full liquidation of your 401(k) account balance following a triggering event;
You retain the company stock in a taxable brokerage or similar account following the distribution, and make a timely rollover of the remaining proceeds of the distribution into your IRA;
The cost basis of the company stock is taxable as ordinary income in the year of the 401(k) distribution;
When you later sell the stock that portion of the proceeds from the sale that represents the difference between the stock sale price and its cost basis (NUA) will be taxable at more favorable long-term capital gains rates in the year of the sale.
Again, this NUA strategy doesn’t work if you sell the company stock while it’s still in the 401(k) or if you transfer it directly into an IRA.
If you own appreciated company stock in your 401(k), the NUA strategy could significantly reduce your tax bill when you sell the stock. However, it’s a complex transaction and isn’t suitable for everyone. Before proceeding, consult a qualified professional to determine whether the NUA strategy is right for you.
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