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A Definitive Guide to Net Unrealized Appreciation (NUA) – Possibly the Best Loophole in the Tax Code
An Introduction & Why You Should Care
Welcome to perhaps my first and last post that doesn’t fit into the ease of readability rating system for MileHighFinanceGuy.com of green, blue, and black. If you are wondering, yes, I got that difficulty scale from the ski resorts here in Colorado.
NUA, known as net unrealized appreciation, is a double black diamond nestled into the snowy peaks of financial knowledge. While it is a complex subject rarely discussed, NUA is a must-know for anyone with a 401(k) plan that offers employer stock.
Why? Because NUA is alone in its ability to minimize taxes on retirement saving withdraws that is rivaled only by the once-per-lifetime IRA to HSA rollover exemption which is the subject of my next post. So, to learn about this ultimate tax arbitrage known as net unrealized appreciation, let’s start with the basics.
How NUA Works
Ordinarily, all withdrawals from pre-tax qualified retirement plans, such as traditional 401(k) and IRA accounts, are subject to ordinary income taxes. The reason for this is because your money goes into them before taxes and grows tax-deferred, then at withdraw, your dues are paid. Thus, the more drawn from your savings, the higher your tax bracket that year!
Through NUA, you take advantage of the generally lower long-term capital gains (LTCG) tax rate and minimize the portion you pay through ordinary income taxes. The resulting arbitrage can save you hundreds of thousands of dollars in taxes throughout your lifetime.
To take advantage of these tax rate differences, you must divide your employer retirement account into two groups. The first group is all monies invested in company-specific stock, and the second group is all monies invested in non-company stock-specific positions, which are generally mutual funds. (If you do not have company stock in your 401(k), then you cannot process NUA but continue reading on, I promise you won’t regret it!)
Once you have divided your account into these two components, you transfer them into separate accounts. The company stock position will leave your qualified retirement account and move into an ordinary, non-qualified after-tax brokerage account; this smorgasbord of words is more commonly known as a brokerage account. The second portion of your money is then transferred into a new qualified retirement account, like an IRA or 401(k) plan.
When completed, you will owe income taxes on part of the company stock position that went into your brokerage account; this portion is known as the stock basis. A stock basis is a fancy way of saying the original purchase price that you paid for the company stock.
The difference between the basis and the current value of the appreciated company stock is your gains. Rather than being taxed as ordinary income, your gains are recategorized from tax-deferred monies to after-tax, unrealized long-term capital gains monies.
The recategorization that occurs is your tax arbitrage, and it is the beauty of NUA. By only paying income taxes on the original stock purchase price, those who have held onto their company stock are rewarded when it appreciates substantially. If your company stock goes down in value, then NUA will be of no value to you!
Confused by the term unrealized mentioned above? Unrealized means that your gains have not yet been captured by closing out the company stock position. Because you have not locked in the profit through selling your employer stock, the amount remains untaxed until sold and realized.
What about the remaining portion that was not in company stock? Generally, this portion is moved into a new qualified plan to remain untaxed; this is called a rollover. While these funds do not have to be rolled over, most people will do so since this portion of their 401(k) is not eligible for the tax arbitrage and is considered dollar for dollar as ordinary income.
To be eligible for NUA, you must have a 401(k) or another form of qualified Defined Contribution (QDC) retirement plan that holds your current or former company’s stock, period. No exceptions. Sometimes these accounts are called Employee Stock Ownership Plans, and other times they are known as Profit Sharing Plans. If you are unsure, ask your plan sponsor or the company HR department. Notably, your company does not have to be publicly traded for NUA to be processed, but the company stock must be able to move in kind. In-kind means that you can transfer the stock out of the 401(k) to another account without selling it. If these points are not met, then NUA is not possible.
While there are many caveats yet to cover, let’s look at an example of NUA first. Once we have demonstrated its functionality and practicality, I will list all requirements to process NUA successfully.
NUA, An Example
Jess works for Microsoft Corporation, which offers a 401(k) that company stock can be purchased within. Jess works for Microsoft for ten years and saves $1,000,000 through the 401(k) plan. During this time, Microsoft matched Jess’s contributions and put all matched dollars into Microsoft stock within the 401(k) plan. Additionally, because Jess believed in Microsoft, another 10% of personal contributions went into the company stock position.
Jess retires at age 60 and is ready to start taking money out of the Microsoft 401(k) plan. Because Jess always saved money through traditional pre-tax contributions, every dollar taken out is considered ordinary income. Always one to optimize their life, Jess employs NUA to pay what is required in taxes, nothing more.
Using NUA, all non-company stock positions will still be treated as ordinary income. Jess does not need to incur a large tax bill at this point. Thus, Jess rolls these funds over to a traditional IRA account. Concurrently, Jess transfers all Microsoft shares to a brokerage account. Jess’s basis in Microsoft will be coded as a distribution of ordinary income during this transfer, on which ordinary income taxes will be owed when filing taxes. The gains Jess has made on the Microsoft stock are then reclassified to unrealized LTCG. Remember basis is a fancy way of saying how much Jess originally paid for all Microsoft shares, both through company match and personal contributions.
For Jess, the basis amounts to $50,000 for all Microsoft shares combined. The total value of Microsoft stock for Jess is $500,000, which means it has appreciated substantially.
Interestingly, it doesn’t matter how long Jess held Microsoft stock within the 401(k) plan. The moment NUA is processed, the gains are recategorized to LTCG, even if the shares have not been held for a year! Generally, long-term capital gains are taxed at lower tax rates than ordinary income, making NUA enticing for the average individual.
Now, because the Microsoft stock is worth $500,000 when Jess processed NUA, an arbitrage occurred where Jess paid income taxes on a meager 10% of the company stock. If Jess is in the 20% income tax bracket, this works out to be $10,000, or a 2% income tax rate.
$50,000 basis * 20% tax rate = $10,000 in ordinary income taxes
For the gains, suppose Jess sells all of the Microsoft stock in that same year. In this situation, assuming Jess incurs no other LTCG, Jess pays $65,000 in LTCG taxes. Thus for withdrawing $500,000 from a retirement account, Jess pays an overall effective tax rate of a meager 15%.
$65,000 ltcg taxes + $10,000 in ordinary income taxes = $75,000 in taxes
$75,000 / $500,000 = 15%
Had Jess withdrawn all $500,000 and not used NUA, a higher ordinary tax bracket would have been applied than 20%, and an effective tax rate in the high twenties would have been used since Jess files taxes as married, joint.
Now with the remaining $500,000 that Jess rolled over to an IRA account, these funds can be withdrawn in future years when needed, keeping their tax-deferred status until then. It is important to note that the 401(k) or QDC account must be zeroed out by December 31st of the year NUA is processed. If this is not done, the NUA is treated as a disbursement of ordinary income for all dollars, destroying your tax savings. Thus, Jess avoids this by zeroing out the Microsoft 401(k) by November 1st of that year.
So, to summarize, Jess moved out $500,000 to an after-tax brokerage account and paid only $75,000 in taxes. Intriguingly, if Jess holds the stock and passes it onto the three kids shared with Jess’s spouse, these gains are stepped up and never taxed. In this different scenario, Jess only pays the $10,000 in ordinary income taxes.
For those unfamiliar with the term, stepped up means that the IRS resets the cost basis from $50,000 in the after-tax brokerage account to the new market value at Jess’s death, say $3,000,000. In this scenario, Jess and Jess’s kids pay no taxes on the LTCG that left the 401(k) plan. However, most people would rather spend some or all the money instead of passing it entirely to their kids.
As for Jess’s household, they had planned to buy a new house using the cash generated by NUA in the original example. Had Jess wanted to purchase a home and not had NUA available, the entire $500,000 would have been taxed at nearly the highest tax rate in America, and Jess would have paid over $175,000 in ordinary income taxes. So, as you can see, NUA is a big deal when the company stock involved appreciates significantly.
What about the other caveats and requirements that you mentioned early? Great question, let’s cover them now!
Net Unrealized Appreciation Requirements & Facts
•What is net unrealized appreciation? NUA is the process of transferring company stock from a 401(k) plan to an after-tax brokerage account to, hopefully, pay an overall lower tax rate.
•Are there any specific requirements for net unrealized appreciation? Yes, individual company stock must be held in your 401(k) and must be allowed to transfer out in-kind. You additionally must have had a triggering event and not have taken money out since then.
•Can you tell me more about triggering events? Absolutely! You must have a triggering event to qualify for NUA. Triggering events are major life events defined by the IRS that include leaving that 401(k) plan’s employer, attaining age 59.5, becoming disabled, or dying. For the first three reasons, the original owner exercises NUA. For the last reason, death, the beneficiaries exercise NUA.
•What did you mean by not having taken money out since the triggering event? Once a triggering event occurs, NUA remains eligible to process until money is taken out of the account. Once any money leaves the qualified defined contribution / 401(k) plan, including RMDs, a timer starts and requires NUA to be processed that calendar year by no later than December 31st.
•Well, shucks, what do I do if I already withdrew money? Suppose you have drawn money since your triggering event, and you didn’t exercise NUA during that calendar year. In that case, you must wait for a new triggering event; the only exception is if the withdrawal was a dividend payment from the company stock made directly to you. Dividends from company stock paid out to you from a 401(k) are not considered a withdraw and do not disqualify NUA if you have had a triggering event.
•Do I have to rollover or remove the remaining funds from my 401(k) besides the company stock? Yes, the IRS requires depletion of the 401(k) or qualified defined contribution account by 12/31 of the same year NUA is processed. If the account is not zeroed out, NUA is disqualified. With NUA disqualified, it does not undo the transfer. Rather it recodes the entire distribution as ordinary income, leaving the processor with a significant tax bill.
•What if my company offers multiple 401(k) or qualified defined contribution plans? In addition to requiring the 401(k) account that NUA is processed from to be zeroed out, the IRS requires all associated retirement plans from that employer to be zeroed out. The easiest way to zero out the additional accounts without incurring taxes is to roll them over. If you are unsure whether an account is regarded as a defined contribution plan, call the plan sponsor and ask them what type of account it is.
•What happens if I am under 59.5? Does the early withdrawal penalty apply? NUA does not waive the early withdrawal penalty of 10% for those under 59.5. If you don’t qualify for an exemption to the penalty, you must pay it. However, the penalty only applies to the ordinary income piece of NUA, not the long-term capital gains portion or rolled-over amounts to other qualified accounts. In the example used above, the 10% penalty would have applied to the $50,000 amount; this means Jess pays $5,000 in penalties to the IRS. For Jess, NUA still makes sense; for you, however, it may not. Ask a tax advisor if you are unsure.
•Can I use net unrealized appreciation to satisfy my required minimum distribution? Yes, NUA can be used to fulfill RMDs and PRMDs (prior year RMDs) for those 72 or older.
•Can I process net unrealized appreciation if I am still working for my employer? Yes, NUA can be processed for individuals still working at a company, but they must be careful to ensure a $0 balance in the account on 12/31 of that year.
•NUA requires the company stock to appreciate. Generally, this means that if you buy and sell and then rebuy the stock, you will have reset your cost basis to whatever the new purchase price was. If company stock is worth less than you paid for it, NUA cannot be exercised.
•What happens if my company merges? If your company merged and your stock goes away, NUA goes away. If your company merges and the stock you own is replaced, the cost basis resets to the new purchase price when your old stock is exchanged into the new one, thus canceling NUA. As someone who worked with NUA daily, I have seen both scenarios occur, so be careful. If your stock remains whole after a merger, NUA is still possible. Additionally, some companies allow NUA to be processed on multiple stocks within their 401(k) from current and former companies they acquired or from different share classes.
•What happens to net unrealized appreciation and Roth dollars in my 401(k) plan? NUA is exercised on pre-tax and or tax-deferred after-tax dollars within a 401(k). There is no point in exercising NUA on Roth dollars since all gains are tax-free. Now, if you hold company stock in the Roth position of your 401(k), most plan sponsors can reassign it to a pre-tax position. The Roth position is then reassigned to a mutual fund that is not eligible for NUA.
•How can I use after-tax dollars within my 401(k) plan to pay fewer taxes when exercising net unrealized appreciation? If you have contributed after-tax dollars to your 401(k), these after-tax dollars can pay down your ordinary income taxes owed on the stock basis. After-tax dollars are contributions made above the standard and catch-up limits to a 401(k) plan. Since you already paid taxes on these dollars, the IRS will let you use them to lower the taxes owed on company stock basis.
Well, I just opened a can of worms with the mentioning of after-tax dollars.
In my opinion, after-tax dollars and net unrealized appreciation can be used in unison to create the holy grail of tax efficiency. To understand why I will now highlight how After-tax and NUA work together through the following example for you.
After-tax NUA Example
After-tax within a 401(k) is not the same as an after-tax brokerage account. As you will remember from my posts: The ABC’s of Retirement Accounts and After-tax IRA & 401(k) Investing, after-tax 401(k) contributions occur when individuals exceed the yearly limits of $19,500 for those under 50 and $26,000 for those 50+, as of 2021. When this happens, contributions continue, but instead of being pre-tax or Roth, they go in as after-tax dollars, where you now pay taxes upfront, but all growth stays tax-deferred. When withdrawn, the initially taxed amount is returned without further taxes. The growth, however, is taxed as ordinary income since it remained tax-deferred. (After-tax is a hybrid of pre-tax and Roth but in a substantially less preferential way.)
With after-tax contributions, they can be assigned towards the stock basis when transferring stock out of a 401(k) during the NUA process. When this is done, instead of owing ordinary income on the basis amount, you owe fewer or no taxes at all now. Additionally, because the stock gains are transferred out as LTCG, you don’t pay income taxes on the deferred growth of your after-tax dollars. Whoa, talk about a win-win that creates massive savings! While relatively rare since most people convert after-tax dollars to Roth nowadays, it still exists since not all plans allow for after-tax conversions.
So, using this new information, let’s tie this back to our previous example with Jess.
Jess has a $1,000,000 Microsoft 401(k) that is half company stock, and the cost basis is $50,000 for the stock. Now, of the $1,000,000 in the account, Jess put in $50,000 as after-tax contributions. Thus, when Jess exercises NUA, the cost basis of $50,000 and is offset entirely by already taxed monies, leaving Jess with no ordinary income tax bill. As for the remaining $450,000, they will be regarded as LTCG when sold. Thus, Jess pays even less in taxes when NUA is processed, and after-tax dollars are used to pay down the stock basis.
Whoa, what a read. My fingers are undoubtedly sore from typing that up, so thank you for taking the time to read through this entire post. As I have illustrated, NUA is a powerful tool. While available only to some, those eligible should consider it due to the substantial savings available to them. By harnessing the power of long-term capital gains tax rates and minimizing what is owed through ordinary income taxes, NUA is a tax loophole unlike any other. While it is rare since many variables must align, NUA is still frequently processed at the large 401(k) providers due to the sheer number of people that hold 401(k) and QDC plans in the United States.
Remember, NUA is a complicated subject. I encourage you to talk to an accountant and or a CFP before acting on NUA, regardless of your financial and tax knowledge level. With how many caveats exist, it is worth the money to hire and consult with an expert. But, enough of what I think. Is NUA the ultimate tax arbitrage, or what do you think of it? Let me know in the comments below and as always, have a great day!
Mile High Finance Guy
finance demystified, one mountain at a time