As a high-earning top performer in your company, managing your compensation wisely is essential for maximizing your benefits, especially when that comes in the form of stock options or other types of equity compensation.
Failing to plan ahead can turn something incredibly valuable into an unnecessary tax burden if you don’t account for the appreciation of those assets.
If you own shares of company stock and are looking for a tax-advantaged strategy for managing them, it may be beneficial to consider a Net Unrealized Appreciation (NUA) transfer.
This article will explain what an NUA is, why it’s advantageous, the general requirements, and how to execute an NUA transfer properly to realize the benefits.
What is a Net Unrealized Appreciation (NUA) Transfer?
A Net Unrealized Appreciation (NUA) transfer involves moving your company stock from your retirement account, such as a 401(k), to an individual brokerage account. Instead of selling the stock and rolling the proceeds into an IRA, you transfer the stock itself.
This strategy allows you to sell the stock immediately after the transfer at a favorable long-term capital gains tax rate.
Why is an NUA Advantageous?
NUA transfers offer several benefits that can support a number of financial goals, from tax minimization, to extra cash flow, and a better-balanced investment portfolio:
- Tax Savings: The basis (the amount originally paid for the stock) is taxed as ordinary income upon distribution. The growth (the difference between the current market value and the basis, or NUA) is taxed at the long-term capital gains rate, which is often lower than the ordinary income tax rate. This could provide significant tax savings, depending on the value of the stock, its growth over time, and the timing of the transfer.
- Penalty-Free Access: Unlike assets in a 401(k), you can access and sell the stock in your brokerage account at any time without penalty, providing liquidity before age 59.5. This liquidity could help supplement your living expenses during lower income years and fund your shorter-term financial goals.
- Risk Mitigation: Selling your company stock may reduce any exposure to a single stock concentration, allowing for better portfolio diversification. Our general recommendation for employees with stock options is to keep the concentration in your employer’s stock at no more than 10% of your overall portfolio. Although not the only strategy to diversify stock concentration, NUA transfers offer a good solution for many. (Check out our blog on 10b5-1 plans if you’re building a concentration, have insider information, and are years from retirement).
General Requirements for NUA Transfers
To qualify for NUA tax benefits, you must distribute your entire 401(k) (with exceptions, outlined below) in a single tax year following a qualifying event such as early retirement or separation of service. The cost-basis of the stock is taxed as ordinary income upon distribution, while the growth is taxed as long-term capital gains when sold.
NUA Tax Savings Example
Consider this example:
- You invested $50,000 of your 401(k) contributions in company stock.
- The value of this stock has grown to $200,000.
- If you distribute the stock via an NUA transfer, $50,000 is taxed as ordinary income.
- The remaining $150,000 of growth is taxed at the long-term capital gains rate when you sell the stock.
- The long-term capital gains rate can be as high as 20%, depending on your income.
The greater the unrealized gain and the lower the basis, the more advantageous the strategy can be.
Qualifying for NUA Tax Savings
To qualify, you must distribute your 401(k) as a lump sum within a single tax year after a qualifying event. If you have taken partial rollovers in previous years, NUA treatment is not allowed.
Qualifying events are death, disability, separation from service, or reaching age 59.5.
Qualifying for this type of transfer is a bit nuanced, so let’s walk through some additional considerations:
- The distribution doesn’t truly have to be a “lump sum”, meaning that multiple distributions can be taken as long as all of them come out in a single tax year.
- If a partial rollover/distribution was taken after a qualifying event in a previous tax year, NUA treatment will not be allowed.
- If a NUA is attempted with just a partial rollover in the current tax year, preferential tax treatment will not be allowed.
- If a distribution/partial rollover was taken at retirement prior to age 59.5, the client will have another opportunity to complete a lump sum distribution after turning 59.5.
Pre-Tax/After-Tax 401(k) Rollover Considerations with NUA
After-tax contributions will typically be applied towards the distribution of company stock shares.
For example, if you made $50,000 in after-tax contributions and have $300,000 worth of company stock with a basis of $70,000, the $50,000 of after-tax contributions reduces the taxable distribution from $70,000 to $20,000.
How to Execute an NUA Transfer
Step 1: Transfer Company Stock to a Brokerage Account
Set up a brokerage account to receive the company stock. Your non-company stock assets, such as your 401(k), should be rolled over to traditional or Roth IRAs as appropriate.
Step 2: Transfer Stock to an Individual Brokerage Account
Ensure the cost basis is correctly transferred to avoid tax issues. Notify your tax preparer of the NUA transfer, as the stock will be listed on your 1099 form with a purchase date equal to the distribution date from the 401(k).
Step 3: Manage the Stock in Your Brokerage Account
You can sell the stock to supplement your cash or retain it for your heirs, who will benefit from capital gains tax rates.
Proceed Cautiously with Professional Assistance
NUA transfers are complex and require careful consideration. It's important to consult your wealth manager to ensure the process aligns with your financial goals and to navigate any potential complications.
If you are executing this type of financial strategy and don’t have a trusted wealth manager on your side, it may be time to consider partnering with Plancorp.
Our team specializes in complexities like this, and can assure that your equity compensation strategies will be guided appropriately to achieve the most beneficial tax treatment and support your overall financial goals.
Not sure if you need a wealth manager? Download our free worksheet for a personalized recommendation based on your specific situation.
