How To Slash Taxes On Employer Stock In A 401(k) Plan

If you hold employer stock in a 401(k) plan, you may have an incredible opportunity to significantly reduce your tax burden. However, it requires understanding and using a unique tax rule known as Net Unrealized Appreciation (NUA).

This article will break down the NUA strategy and outline the steps you need to follow to maximize this tax-saving potential.

Why Employer Stock in a 401(k) Matters

When your employer’s stock is held within a 401(k) or similar retirement plan, it’s typically taxed as ordinary income upon withdrawal. However by using the NUA strategy, you could convert a portion of this tax burden into a lower long-term capital gains rate, resulting in a significant tax break.

Here’s the catch: this tax-saving strategy requires careful planning, as it’s only effective if you adhere to specific rules. Let’s walk through the essential steps.

Understanding the NUA Strategy

The NUA strategy provides a valuable tax break by allowing you to move employer stock from your 401(k) to a taxable brokerage account in a way that minimizes your tax burden. Here’s how it works.

Step 1: Roll Over Non-Employer Assets to an IRA

To start, you’ll need to separate your employer stock from other assets in your 401(k). Follow these guidelines:

• Roll over non-employer stock assets: Transfer everything in your retirement account that isn’t employer stock to a traditional IRA. This rollover should be tax-free if done correctly.
• Leave employer stock in the 401(k): Ensure that only employer stock remains in your retirement account. This sets the stage for the NUA tax benefit.

“The key tax break is known as net unrealized appreciation, or NUA. It can be very valuable, but you must know and follow the rules.”

Step 2: Distribute Employer Stock to a Taxable Brokerage Account

Next, move the employer stock from your 401(k) into a taxable brokerage account. This step is crucial for the NUA benefit:

• In-kind distribution: The stock must be transferred directly in its current form to a taxable account without rolling it into an IRA first.
• Tax on cost basis: In the year of this distribution, only the cost basis of the employer stock (original purchase price) is included as ordinary income.

This step defers taxes on the stock’s appreciation, which will only be taxed when you sell the shares in your taxable account.

Step 3: Pay Capital Gains Tax on Appreciation

Once the employer stock is in your taxable account, the tax advantages continue. As you sell the stock:

• Capital gains on appreciation: You’ll pay long-term capital gains tax on the appreciation of the stock (the increase in value from the original purchase price).
• Tax deferral benefit: There’s no rush to sell. You can hold the stock until you’re ready, allowing your investments to grow without triggering tax.

“This is the rare opportunity to both defer the taxes until you sell the stock and then have the appreciation taxed at long-term capital gains rates.”

Key Rules for NUA Treatment

For the NUA strategy to work, strict rules must be followed. Here’s what you need to know:

Lump Sum Distribution Requirement

To qualify for NUA tax benefits, you must take a full, lump-sum distribution from the 401(k) within a single calendar year:

• All assets out at once: Every asset in your 401(k) must be distributed in the same calendar year, including rolling over non-employer stock to an IRA and moving employer stock to a taxable account.
• Timing matters: Any withdrawals in previous years disqualify you from using NUA, even if they were required minimum distributions.

Triggering Event Needed

Additionally, the lump sum distribution must be triggered by a specific event:

• Qualifying events: Reaching age 59½, leaving the employer, or death are all qualifying events that permit you to initiate a lump sum distribution.
• Flexible timing: The triggering event and distribution do not have to occur in the same year. For example, if you left your employer years ago, you can still take the lump sum distribution now.

Considerations for Heirs and Divorced Spouses

NUA treatment may also be beneficial for heirs and divorced spouses:

• Inherited stock: Heirs who inherit the 401(k) can also take advantage of the NUA treatment by following the lump sum distribution rules.
• Divorce scenario: Divorced spouses receiving a portion of the retirement account via a qualified domestic relations order (QDRO) can also use the NUA tax strategy.

When NUA Isn’t the Best Choice

While NUA offers impressive tax savings, it isn’t suitable for every situation:

• High-cost basis: If the employer stock’s cost basis is high relative to its current value, the NUA tax benefits may be limited.
• Growth potential: Consider whether the stock is likely to continue appreciating. If you’re uncertain about the stock’s performance, keeping it in a retirement account may be preferable.

The NUA strategy works best when there’s a large gap between the cost basis and the current value, allowing you to take full advantage of long-term capital gains tax rates on the appreciation.

Final Takeaway: How To Leverage NUA for Tax Savings

For those with substantial employer stock in a 401(k) plan, the NUA strategy can be a powerful tax-saving tool. Here’s a quick recap of the steps to follow:

1. Roll over non-employer stock to an IRA.
2. Distribute employer stock directly to a taxable account.
3. Ensure a lump sum distribution within one year.
4. Sell the stock at your discretion, benefiting from capital gains tax rates.

This approach can allow you to minimize taxes while still benefiting from the growth of employer stock after it leaves your retirement account. Before making any moves, consult a financial advisor to confirm if this strategy aligns with your financial goals and retirement plan.