Owners of 401(k)s have options when they retire from their job. They can roll their entire 401(k) into a traditional IRA, which is the preferred route taken by many account owners, or they can leave funds in their former employer’s 401(k).
These decisions are based in part on a comparison of the available investment choices and the costs of each option, plus the ease of having all 401(k) assets in one IRA for a person who has had many jobs over his or her working life. Of course, you can also take a lump sum withdrawal of all your 401(k) assets in a taxable distribution, but this isn’t recommended because you would owe tax on the distribution.
Retirees who hold employer stock in their 401(k) can make use of a popular tax-savings strategy known as net unrealized appreciation (NUA). This strategy is for workers who purchased stock of their employers through their 401(k) over the years, and that stock has appreciated in value.
Provided you are 59½ or older when you retire, you can elect to take a lump-sum distribution of the company stock and put it in a taxable account, while transferring the remaining 401(k) assets in a tax-free rollover to your IRA. You can also do this before age 59½, but you would then owe a 10% early distribution penalty.
There are two main federal tax consequences of the net unrealized appreciation strategy. First, you will pay tax at ordinary income tax rates on the cost basis of the shares in the year of the distribution from your 401(k). You will owe tax up to the top 37% rate only on the cost basis of the shares, meaning what your 401(k) account originally paid for the stock of your employer.
Second, when you eventually sell those shares, the built-in appreciation is treated as capital gain. The amount of net unrealized appreciation, which is the difference between the fair market value of the shares and cost basis on the date the shares are distributed from the 401(k), is taxed as long-term capital gain when the stock is sold. The long-term capital gain rates are currently 0%, 15% or 20%, depending on your taxable income.
If, following the 401(k) distribution, you hold the stock in your taxable account for more than a year before selling the shares, then any post-distribution appreciation or gain will also be taxed at long-term capital gain rates. If you hold the stock in your taxable account for a year or less before selling it, then the post-distribution gain is taxed as short-term capital gain, meaning it’s taxed at ordinary federal income tax rates up to 37%. However, even if you sell the company stock less than a year after you receive it from your 401(k), the net unrealized appreciation is still taxed as long-term capital gain. It’s only the post-distribution portion of the gain that will be considered short-term capital gain.
The effect of this strategy is to convert higher-taxed ordinary income into lower-taxed capital gains on the built-up net unrealized appreciation in the stock.
Here is a net unrealized appreciation use example
Let’s say a 70-year-old retiring worker in 2024 has employer stock in her 401(k) account that was acquired with pre-tax retirement contributions. The stock has a $75,000 cost basis and a current fair market value of $250,000.
At retirement, she transfers the non-employer-stock assets into a traditional IRA in a tax-free rollover and takes a taxable distribution of all her employer stock and puts it in a brokerage account. For 2024, the year of the 401(k) distribution, she will owe tax at ordinary income tax rates on the $75,000 cost basis.
Assume that three years later, in 2027, she sells the stock for $315,000. The $175,000 net unrealized appreciation ($250,000 - $75,000) and the $65,000 post-distribution gain ($315,000 - $250,000) will be taxed at long-term capital gains rates. If she is in the top federal tax bracket, her total tax could be up to $75,750 (($27,750 ($75,000 x 37% top rate) + $48,000 ($240,000 x 20% top CG rate)).
If she instead sold the stock shortly after the 401(k) distribution, then she would owe tax at ordinary income tax rates on the $75,000 cost basis and long-term capital gains rates on the $175,000 net unrealized appreciation. If she’s in the top federal tax bracket, her total tax in this second situation could be up to $62,750 ($27,750 ($75,000 x 37% top rate) + $35,000 ($175,000 x 20% top CG rate)).
Compare the above example to transferring the employer stock directly into a traditional IRA upon retirement. The woman in the example would delay the immediate tax hit in 2024 on the transfer of the stock from the 401(k). She defers the tax on any dividends earned on the stock, but she also loses the favorable tax break for qualified dividends when she takes required minimum distributions (RMD), which are treated as ordinary income.
If the stock is eventually distributed to her from her IRA, she would pay tax at ordinary income tax rates on the full value of the shares, including on the net unrealized appreciation and the additional appreciation that built up in the shares when they were stashed in the IRA.
If she has the IRA sell the stock, she eventually must take required minimum distributions from the IRA that are taxed as ordinary income. If the IRA sells the stock for $315,000 in 2027 and she begins taking RMDs, the total tax hit over the years on distributions of that $315,000 from the traditional IRA at a 37% top ordinary tax rate would be $116,550. That’s $40,800 more in taxes than she would have paid had she taken advantage of the NUA strategy.
You could see a bit less tax savings from the net unrealized appreciation strategy if you are subject to the 3.8% tax on net investment income. And you could potentially see larger tax savings if you can stretch out the net unrealized appreciation strategy by selling off only a portion of the shares in the taxable account each year. That could lower your capital gains tax hit to 15% or even to 0%, depending on your taxable income.
The bottom line on net unrealized appreciation
The net unrealized appreciation strategy isn’t for everyone. For instance, it makes sense when the stock has substantially appreciated in the 401(k). The lower the cost basis in the shares and the higher the appreciation, the more tax-advantageous the strategy. The difference between the tax rates on ordinary income and capital gains is also a factor. The greater the differential between the rates, the more attractive the strategy looks from a tax perspective.
Another thing to consider is potential changes to tax rates. For example, will the future tax rate when the stock is sold be lower than in the year of retirement because the retiree is earning less income or because of a legislative change? And don’t forget state taxes.
There are also non-tax factors to consider. They include the liquidity of your retirement assets, your time horizon, your risk tolerance level, and whether you eventually plan to donate some of the distributed stock to charity.
Note: This item first appeared in Kiplinger’s Retirement Report, our popular monthly periodical that covers key concerns of affluent older Americans who are retired or preparing for retirement. Subscribe for retirement advice that’s right on the money.
