If you have publicly-traded employer stock inside your 401(k) plan then you may have heard of a strategy called net unrealized appreciation (NUA). The basic idea is that once you are eligible, you have an opportunity to rollover the employer stock in a very specific way and possibly save a tremendous amount of money in taxes. However, the strategy is not always as beneficial as it appears. In many cases, you may be better off by not engaging in NUA at all. Even if that means you will pay more in taxes.
What Is NUA?
Let’s first start with a discussion about exactly what NUA is. If you have publicly-traded employer stock in your 401(k) plan, then you can execute an NUA strategy if you are no longer working for the company, age 59½, deceased or disabled. These are known as “triggering events.” Under the rules (IRC Section 402), if this stock has gained in value over time, then the rules of NUA state that you can rollover your company stock to a taxable brokerage account and rollover the remaining assets to a tax-deferred IRA. (For related reading, see: Company Stock in 401(k)s: The Risks and Rewards.)
The price you paid for the company stock, known as cost basis, would then be taxed at your ordinary income tax bracket. And once the stock is ultimately sold, you would only have to pay long-term capital gains tax on the difference between the costs basis and fair market value - based on the value when stock was distributed from 401(k).
When you have company stock in a 401(k) and face a triggering event, you basically have three options:
- Leave the 401(k) in place.
- Rollover entire 401(k) to an IRA.
- Execute an NUA strategy.
I’ll focus on options two and three.
Rollover Entire 401(k) to an IRA
Assume that you’ve been working for your employer for many years and you paid $25,000 for the employer stock in your 401(k), but it is now worth $100,000. Also assume that you are in the 25% tax bracket. If you rollover the entire 401(k) to an IRA, then you will pay ordinary income tax on the entire amount of the $100,000 when it is eventually withdrawn. For simplicity sake, we’ll assume that it is all withdrawn at one time. That would result in $25,000 ($100,000 x 25%) being owed to Uncle Sam.
Execute NUA Strategy
Under NUA, you would pay 25% ordinary income tax on the $25,000 cost basis plus 15% long-term capital gains tax on the $75,000 in gains. That equates to a tax of only $17,500, much less than the $25,000 above. Note that the capital gains tax can actually be deferred to the future if you desire, but I’m assuming that the employer stock is sold today and tax subsequently paid so that we can compare in a like manner to the IRA. (For related reading, see: What Determines Your Cost Basis?)
The $7,500 tax savings ($25,000 - $17,500) that is present is essentially why NUA is so popular. However, you should be careful to not let the tax tail wag the investment dog.
Tax Savings Today (NUA) Versus Tax Deferral (IRA)
While it is true that there is significant tax savings by choosing NUA, it doesn’t mean that you will end up with more money in the long run.
Example: Let’s continue with the information from above and assume that in addition to a 25% tax bracket and 25% cost basis (percentage of cost basis relative to market value) that you also have an investment time horizon of 30 years, can earn 8% per year, have a 15% long-term capital gains rate and are age 45. At the end of 30 years, you will have $755,000 after tax if you rollover to an IRA but only $576,000 with the NUA strategy. That’s a $179,000 advantage for the IRA.
What’s interesting is that even though the IRA had a higher balance, you also would have paid considerably more tax under that scenario ($251,566 IRA versus $87,484 NUA). In case you didn’t catch this, let me say it in a different way. You pay $164,000 more in tax by rolling over your 401(k) to an IRA, but you end up with $179,000 more money after tax. This just goes to show you that taxes should not be your primary focus - ending value should.
Note that in this example and all other examples that follow, I am ignoring the effect of required minimum distributions required on IRAs once you reach age 70½. (For related reading, see: Understanding Required Minimum Distributions.)
Other Examples Where NUA Is Unfavorable
The example presented above is likely a very common situation for a person to be in. And while this particular example shows that NUA is unfavorable, following are a few more situations where the same holds true:
- Age 40, 25% tax bracket, 15% long-term capital gains rate, 50% cost basis, 8% rate of return and 30-year time horizon.
- Age 50, 40% tax bracket, 20% long-term capital gains rate, 25% cost basis, 8% rate of return and 30-year time horizon.
- Age 60, 25% tax bracket, 15% long-term capital gains rate, 10% cost basis, 6% rate of return and 20-year time horizon.
Are There Situations When NUA Works Out?
Please understand that I am not saying that NUA is always a bad idea. I’m just saying that in many cases, NUA is not as beneficial as many would have you think. You truly have to run the numbers for every person’s unique situation to determine if NUA is a worthwhile strategy. With that said, following are three situations where NUA can work:
- Age 40, 25% tax bracket, 15% long-term capital gains rate, 25% cost basis, 8% rate of return and five year or less time horizon. Anything above a five-year time horizon tilts the advantage to the IRA.
- Age 50, 40% tax bracket, 20% long-term capital gains rate, 50% cost basis, 8% rate of return and five year or less time horizon. Anything above a five-year time horizon tilts the advantage to the IRA.
- Age 60, 25% tax bracket, 15% long-term capital gains rate, 10% cost basis, 6% rate of return and 13 year or less time horizon. Anything above a 13- year time horizon tilts the advantage to the IRA.
As you can see, there is no one-size-fits-all approach. Everyone’s situation is truly unique. However, there is one major assumption that really stands out when comparing the IRA to the NUA strategy and that is time horizon. As you increase the time horizon, the IRA becomes more favorable. But as you decrease the time horizon, the NUA strategy starts to become more appealing.
Additionally, there is one other trend that stands out. As you collectively reduce the cost basis, reduce the time horizon, reduce the rate of return and increase the ordinary income tax bracket, the NUA strategy starts to become more favorable.
In summary, for the vast majority of people out there, who likely have a long term time horizon, NUA probably does not make sense. But for those people who need money today or in the very near future, then an NUA strategy may be best. And always remember that there is more to the picture than taxes. (For related reading, see: Why You Need to Know Your Cost Basis.)