When people leave an employer, they often have numerous rollover options for money saved in a 401(k) through that company. One such option is known as net unrealized appreciation (NUA).
People who opt for NUA can treat company shares differently from other investments held in the account instead of transferring all investments as a lump sum into an IRA or a new employer-sponsored account. NUA involves taking company shares and distributing them to a taxable brokerage account while rolling over the rest of the assets in the 401(k) in more traditional ways.
The primary motivation for using rollover schemes when leaving an employer is prolonging the tax-advantaged status of retirement investments. Individuals continue to add to the portfolio without paying any taxes until money is withdrawn in retirement, at which point taxes are incurred.
Often, people choose to keep company shares with the account and add them to the new portfolio. However, NUA makes it possible to distribute these shares to a taxable account. This involves paying taxes on the cost basis of the shares rather than current market value.
Why Would People Choose NUA?
People may choose to take advantage of NUA for many reasons. One of the primary motivations is when the stock price has appreciated a great deal over the cost basis for the shares. Individuals will pay lower tax on the cost basis now and then be able to sell the shares at a profit in the future.
Of course, individuals will still need to pay capital gains tax on the profits, but these rates will typically be lower than one would pay on the amount withdrawn from a retirement account. When rolled over to another retirement account, the shares would get taxed as ordinary income rather than capital gains, resulting in a higher overall tax burden.
Another advantage that comes with taking the NUA option is diversification. People who have the majority of their assets in tax-deferred retirement accounts may enjoy the liquidity of a taxable account, which has different rules and opens up new options for investing. This advantage holds true even if the current market value of shares is not much higher than overall cost basis.
While economically it may make the most sense to roll the shares over into another account, people who could benefit from diversification may still want to opt for NUA. That being said, individuals should always calculate the tax burden they will incur with NUA and have a plan for how they will cover the cost in that calendar year.
What Are the Specific Rules of NUA?
Importantly, there are clearly defined rules about using NUA that need to be followed. For example, individuals need to take a full distribution of all funds in an account by the end of the calendar year when opting for NUA. In other words, all assets must be withdrawn or rolled over before the end of that year.
This is important since some people choose to leave funds in the 401(k) of a former employer instead of rolling them over, which is not permissible with NUA. Also, NUA is typically only available after certain triggering events, such as leaving an employer or filing for disability.
Another consideration relates to estate planning. Under normal circumstances, the shares of stock in a taxable account receive a step-up in basis when they get passed to heir, but this is not true with NUA. The cost basis for the heir would be the same as the owner had at the time the NUA was distributed. Unfortunately, what this means is heirs could actually have a significantly higher capital gains tax bill once they sell the shares. People need to keep this in mind when they are deciding whether or not to use NUA.
Which Issues Are Most Important?
Several issues deserve consideration as individuals ask themselves whether or not NUA is a good option for them. Perhaps the most pressing is the current tax burden. With a rollover, no taxes need to be paid. NUA requires that people pay the taxes in the current year, even though doing so may lower their capital gains tax burden in retirement.
Much of this decision depends on the outlook for the stock, which is another key consideration. No one can predict the future, but individuals may have some idea of whether or not the stock is expected to grow or fall in value in the future. If the price of shares is expected to decline, then NUA has no real advantage beyond diversification, which is attainable through other means.
Another consideration is the proportion of a portfolio accounted for by the shares. If the shares make up a large portion of the portfolio, the move that makes the most sense could be rolling shares into an IRA and then selling them within that account to purchase new investments and diversify the portfolio further.
Other points to consider include the timeframe until retirement and the time value of the shares in a taxable or tax-deferred account. In the end, no right or wrong answer exists. Investors may want to talk more about options with a professional, especially with so many questions at play.