A 401(k) Tax Break That’s Often No Break

BY ROBERT J. DIQUOLLO

  

 
 

Withdrawing company stock from a 401(k) to take advantage of a tax break called net unrealized appreciation (NUA) sounds like a no-lose proposition, and most advisers tell their eligible clients to go for it. But there’s just one big problem: When you run the numbers, this maneuver often doesn’t pay off.

Many employees accumulate substantial company stock in their 401(k), especially if they have worked for the company many years and the stock has done well. (And the individual may be overconcentrated in it.)

When the employee retires, leaves the company or otherwise qualifies for a lump-sum distribution, he or she may remove the stock from the plan and put it in a taxable account but still get favorable tax treatment. Only the cost basis of the stock counts as ordinary taxable income. When the stock is sold, the additional “unrealized” appreciation that occurred within the 401(k) is taxed at long-term capital gains rates. So if the stock’s basis is $20,000 and it’s now worth $100,000, the transfer and an immediate sale will produce $20,000 in ordinary income and $80,000 of long-term capital gain. Most people who take advantage of NUA sell the stock immediately, but this isn’t required. Any sale after the transfer out of the 401(k) will produce a separate long- or short-term gain or loss.

However, be aware that a 10% withdrawal penalty for early distribution could apply if the employee is under age 59½, unless he or she is at least 55 and there is a complete separation from service. To determine full eligibility and make sure other requirements are met, see IRS Publication 575.

In contrast, if the stock is rolled over into a traditional IRA, the entire amount will be counted as ordinary income as it’s withdrawn during retirement. Potentially, the tax savings under the NUA approach can be substantial. So what’s not to love? Plenty.

Before advising your client to take the NUA option, run the numbers. On a spreadsheet, simulate the distribution, sale and federal and state tax returns, including the resulting additional capital gains and ordinary income. Now, assume a realistic after-tax rate of return over time on the remaining asset.

Next, compare that scenario with rolling over the stock into an IRA, selling it tax-free inside the IRA, assuming a suitably higher pre-tax rate of return, and paying taxes on the mandatory distributions starting at age 70½.

You’ll probably discover that the NUA approach works best only when the cost basis is very low or the investment horizon is relatively short. Otherwise, as shown in the chart below, the client will have more money in the long term by transferring the stock to an IRA. With NUA, the funds grow at after-tax investment rates. In contrast, keeping the money in the IRA lets the entire amount grow until distributions start. And, while those distributions are fully taxable, the interim tax-deferred buildup—at higher, pre-tax, investment rates—can be substantial.

Of course, there are situations in which the NUA option may be more profitable. If the client needs the money in the short term, taking advantage of NUA can make perfect sense. For many people, though, net unrealized appreciation is a net loser

By Robert J. DiQuollo, CPA/PFS, CFP, a senior financial adviser with Brinton Eaton Wealth Advisors, in Morristown, N.J. He can be reached at diquollo@brintoneaton.com.

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