Net Unrealized Appreciation – When to Avoid and When to Use this Overhyped Tax Technique

Time to Read: 7 Minutes

A little-known tax rule for people who own their employer stock in their 401(k) is Net Unrealized Appreciation (NUA).  Electing NUA is often promoted by retirement planners as a smart tax savings strategy.  Here in San Diego, we’ve helped clients from companies with highly appreciated stock, such as SAIC, to evaluate this strategy.  There is no shortage of articles on the web praising this. However, it may appear advantageous on paper, but it rarely makes sense in real life.  This article covers the basics of NUA, the tradeoffs when considering it, and when to actually use NUA in real life.    

How Does Net Unrealized Appreciation Work? 

Many companies allow employees to invest their 401(k) in the stock of the employer.  When the stock of the employer does particularly well, these workers may find themselves with a highly concentrated portion of their retirement portfolio invested in their company’s stock.  This stock is owned with a very low cost basis or purchase price.  Normally, when an employee retires and begins taking funds from his or her 401(k), the money withdrawn is taxed at ordinary income tax rates.   

However, the IRS tax code allows gains in employer stock to be taxed at long-term capital gains rates in some cases. This favorable tax treatment, termed Net Unrealized Appreciation, requires several qualifications in order to be met.  Because long term capital gains tax rates are generally lower than income tax rates, this tax treatment is potentially beneficial to investors with employer stock in their 401(k).   

Net Unrealized Appreciation is simply the difference between the cost of shares of employer stock and their current value.  If you purchased shares of stock for $5 per share inside of your traditional 401(k), and the stock now trades at $80 per share, your Net Unrealized Appreciation or NUA is $75 per share.  Again, if certain conditions are met, you may be able to pay lower long-term capital gains rates on the $75 per share of NUA, which can be a substantial savings over income tax rates. 

First, as mentioned above, there are requirements which must be met to receive capital gains treatment on the sale of stock, using NUA: 

1. The entire 401(k) plan balance must be distributed in a lump sum (within the same year).  To elect NUA, workers must transfer their employer stock from their 401(k) plan into a non-retirement account. A non-retirement account could be an individual brokerage account, joint account, or a trust.  401(k) funds which are not invested in your company stock must also leave the 401(k), but they can be rolled over to an IRA, for example. 
    
2. The employer stock on which you’d like to elect NUA treatment must be moved in-kind.  Moving the stock in-kind simply means the investor moves the shares of stock to the non-retirement account.  He or she does not sell the shares first and then transfer the cash proceeds. 
    
3. You must have satisfied a “qualifying event” such as separation from the company, reaching age 59.5, total disability, or death.  Most often, NUA is elected upon separation from the company at retirement.   

Once someone elects NUA and moves the shares of stock out of the 401(k) plan, he or she must immediately pay income taxes on only the cost basis of the shares ($5 per share in the example above) but not the entire value of the shares ($80 per share in the same example).  In exchange for this, the investor is now free to sell the shares and pay long-term capital gains taxes on the $75 per share of NUA.  Federal long-term capital gains rates may be 0%, 15%, or 20%.  The rate you pay, depends on the level of your taxable income in the year in which you pay.  Income tax rates, on the other hand, are generally higher than long-term capital gains rates.  Because of this, any sales of stock using NUA benefit from a lower rate, leaving the investor with more money to spend.  This simple intuitive example leads many financial planners and investors to assume NUA should be elected for employees with company stock in their 401(k).  Not so fast…  

Why NUA Analysis Can Be More Complex Than Meets the Eye 

In short, NUA is valuable when post-tax wealth is maximized.  This is no different than any other financial decision.  Naturally, determining how to maximize after-tax wealth can quickly become a complex endeavor.  This analysis involves assumptions about tax rates now vs where they may be in the future, investment growth assumptions, one’s spending needs from their investment portfolio, and more.   

At BWM, we’re well-versed in assisting affluent clients on the intricacies of high-stakes financial decisions.  We understand the important tradeoffs and have the tools to assist with modeling different financial scenarios to determine the best course of action.  Everyone’s situation is different, so we encourage you to reach out to schedule a consultation with one of our Wealth Advisors to discuss your plans – CLICK HERE.  In the meantime, here are some important rules, tradeoffs and considerations to weigh.    

What Are the Tradeoffs When Considering NUA? 

Electing NUA treatment for stock held in your 401(k) plan can make sense in some cases.  However, this strategy comes with an opportunity cost which makes it less beneficial than one might think.   

The decision to apply NUA is a tradeoff between two competing benefits.  With NUA, the investor receives a favorable blended tax rate – income tax on the cost basis now and long-term capital gains taxes upon the sale of the stock.  If NUA is not elected, the investor pays the higher income tax rate on the appreciated value, but this tax may be paid potentially years down the road when funds are withdrawn from the 401(k) account.  This tax deferral is valuable, and it’s partially lost when electing NUA.  In other words, the decision to elect NUA often can be boiled down to paying a lower tax rate or deferring taxes for longer.   

Inside of a traditional 401(k) plan, an investor may sell profitable investments, and earn dividends/interest, etc. without paying any taxes.  Money which would have otherwise been paid in taxes in a non-retirement account, is still available to grow, earn dividends, interest, etc. if invested inside of a 401(k).     

The most intuitive drawback to NUA is the loss of this deferral and immediate taxation of the cost basis of the NUA stock at income tax rates.  This cost can be significant unless the basis is quite low.  Therefore, NUA works best with stock which is very highly appreciated.  To illustrate this point, imagine an extreme example: 

Two employees work at the same company, each with $500K of company stock in their 401(k) plan.  Employee #1 was hired many years ago and paid $5,000 for the stock now worth $500,000.  Employee #2 paid $400,000 several years ago for the same number of shares worth $500,000 today.   

Upon NUA election at retirement, employee #1 would pay income tax on the $5,000 cost basis and eventually pay lower capital gains rates on the remaining $495K when he or she eventually decides to sell.   

Employee #2, on the other hand, must pay income tax immediately on the cost basis of $400,000, in order to receive an eventual benefit of a lower tax rate on the $100,000 of gains when he or she sells.  It’s clear to see that NUA works much better with very highly appreciated stock (in other words, stock with a very low cost basis). 

Imagine now, that you find yourself nearing retirement after a successful career at a company with a high performing stock.  You’re employee #1 in the example above. You own a large portion of your 401(k) account in one single stock.  Your basis is extremely low.  For these reasons, NUA might look appealing.  Surprisingly, these same circumstances might cause NUA to be an inferior strategy.  Here’s why… 

Diversification Is An Important Benefit, and NUA Can Make it Costly 

NUA makes it more costly to successfully diversify one’s portfolio.  To sell and diversify company stock after electing NUA, the employee must pay capital gains tax on the sale.  This further accelerates the tax payments when NUA is utilized.  This taxation may become a reason to keep more company stock and accept the associated risk that comes with owning a large portion of one’s portfolio in one company.   

As mentioned above, most investors deciding whether to use NUA are considering this strategy at the end of a career when they are unable to tolerate large financial risks.  In addition, the strategy makes sense for highly appreciated stocks which may be quite expensive and especially well-suited for diversification, which reduces portfolio risk.  A large holding in one individual stock can make or break a retirement plan.  Even successful, well-established companies can face unforeseen circumstances, which can dramatically reduce the value of the company stock. NUA makes more sense when one does not wish to sell or diversify a large portion of his or her company stock.   

Selling an investment inside of a 401(k) plan or IRA, to diversify into a more predictable portfolio, generates no tax bill.  The proceeds from the sale of the single employer stock can be reinvested to pay retirement income, potentially grow, and maintain tax deferral until one needs to spend the funds.  Many large retirement accounts are spent slowly over the course of many years by a retiree.  Distributions (and thus taxes) are spread out, taxed as income in the year in which they are taken, at oftentimes a low rate in retirement.  This ability to diversify one’s company stock now, invest the proceeds for retirement, and maintain tax deferral is valuable.   

Simply put, when cost basis on NUA is very low and the income tax bill for electing NUA is minimal, an investor may face a tough choice: an additional tax bill for the sale of NUA stock to diversify or taking undue risk of owning the single stock for the long-run.  In our opinion, tax savings should never come at the cost of an unstable retirement.   

When Should Someone Use NUA? 

There are three cases when NUA absolutely makes sense.  First, when basis is low and an investor intends to hold a portion of his or her company stock for the long-run, NUA can be a great choice.  Companies offering stock in their 401(k) plan tend to promote ownership culture.  The employees benefit from the growth of the firm and feel a sense of pride in their career and contribution to the success of the firm.  It’s common for these folks to want to hold company stock for the long-term, as a link to the company.  If the value of this stock is not so large that it could jeopardize one’s retirement plan in the event of a major price decline, one might choose to hold the stock.  Electing NUA, paying a small tax bill on low basis shares, and holding those shares is actually a great way to defer taxes!  Capital gains are not realized until shares are sold.  This hold strategy can work especially well if the stock pays little or no dividends which would be subject to tax each year.   

Next, NUA can even work well for relatively high-cost basis shares when an investor needs current retirement income from their 401(k).  This may sound strange to consider higher basis shares for NUA treatment, but it’s true.  Consider an investor who meets the requirements for NUA treatment with a basis of $60 per share and a current stock price at $80 per share.  NUA might not look attractive, as you should now understand that electing it would generate an immediate tax of income on the $60 per share of basis.  However, many newly retired investors need to begin taking income from a retirement account right away.   

Without an NUA election, the investor would pay income tax on the entire $80 per share this year, to withdraw the funds needed for living.  With NUA, the same investor pays income tax on the $60 basis and long-term gains on the $20 per share of NUA (the difference between the $60 basis and the $80 market value).  For investors with company stock in a retirement account, needing immediate cash from the account to fund retirement expenses, NUA works well at just about any cost basis.  The stock is sold right away.  Tax deferral and immediate taxation of basis as income are not drawbacks.  NUA can and should be elected when company stock is owned inside of a 401(k) and cash is needed in early retirement from a 401(k) plan.   

Lastly, NUA can be an especially powerful tool for investors who have capital loss carryforwards.  When an investor sells an asset for less than he or she paid, the IRS allows the taxpayer to record this loss and use it to offset capital gains from the sale of other investments.  From time to time, we meet investors with large capital losses from failed investments in their past.  These losses cannot be used to reduce income taxes (except for a small, $3,000 per year allowance).  However, they never expire and can be “carried forward” indefinitely.  Someone with $500,000 of losses from a bad investment 20 years ago, may still have those losses available to be used today.  Selling company stock after an NUA election can free these losses to be used!  Remember that the difference between the cost basis and the fair market value of the stock is taxed as long-term capital gains after an NUA election.  Investors with large capital loss carryforwards and highly appreciated company stock in a retirement plan may be prime candidates for an NUA election.      

How can BWM Financial Help? 

Little known financial strategies, such as NUA, are marketed by financial firms.  They may seem appealing at first glance.  Applying these techniques in the real world is a different matter. It can lead to unintended consequences and sub-optimal outcomes when not fully considered.  A wealth management team with perspective and real-world experience implementing investment strategies can be an invaluable tool for high-net-worth families.  At BWM , we guide clients through high-stakes financial decisions all the time.  Our understanding of the tradeoffs, use of sophisticated financial modeling, and extensive experience help us distill complex considerations into simple actionable advice.  Then we help our clients implement the actions they need to take to get it done. Then clients are free to get back to living their lives, knowing they’ve made the best possible financial choices.  If you’d like our help considering a critical financial decision, such as whether to elect NUA, please schedule a consultation with one of our Wealth Advisors today – CLICK HERE.   

Investment advice offered through Stratos Wealth Partners, Ltd., a Registered Investment Advisor DBA BWM Financial.  The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Stratos Wealth Partners and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.