If you work with retiring clients who own their employers’ stock in their 401(k) plans, the clients may have a unique opportunity to potentially save a bundle on taxes by taking advantage of special rules related to the net unrealized appreciation (NUA) on those shares.
The optimal clients for this strategy are those who can initiate the distribution of the shares in a year in which the clients will otherwise have minimal taxable income from earnings, pensions or Social Security. Better yet, they will also have enough funds held outside of sheltered retirement accounts, so that the clients can tap those funds tax free to cover living expenses, and only sell enough of the NUA shares until the capital gains reach the top of the 0% long-term capital gains tax rate. Finally, the clients will have a large enough portfolio so that their entire financial future isn’t tied to the ups and downs of their (former) employer’s stock.
But beware, the execution of this tactic can be treacherous, and might not be as beneficial as the clients (and you) initially perceive.
Section 402(e)(4) of the Internal Revenue Code allows employees to transfer some or all of their employer’s stock out of the employees’ retirement plan (i.e. their 401(k)) in kind and to a non-tax-sheltered account. However, the shares can only be distributed due to a “triggering event,” defined by the tax code as the employee’s death, disability, separation of service or reaching age 59 1/2. The cost basis of the transferred shares is taxable as ordinary income to the employee in the calendar year of the distribution. Then if/when the employee sells the shares, any gains above the cost basis are taxed at long-term capital gains tax rates, regardless of when the shares were actually purchased.
Only certain kinds of employer shares qualify, so the clients should check with the employer’s benefits department or plan administrator to find out if their particular shares are eligible for the NUA treatment, and what the cost basis of the shares may be. There is no requirement that all of the shares held in the employee’s retirement account are distributed in this manner. And to qualify for the NUA designation, the shares must be part of a lump sum distribution—meaning the entire amount of the retirement account has to be distributed within a particular tax year.
The Taxation of the NUA Shares
There are two stages in which the stock shares distributed via the NUA strategy could be taxable to the clients. The first is when the shares are transferred in kind from the clients’ 401(k) to their individual or joint investment account and the cost basis amount is added to the clients’ taxable income for that year. The second potential taxation will arise when the distributed shares are sold. Any gains above the cost basis will be taxable as long-term capital gains (and any realized losses can be used like any other loss taken via stock sale).
The trick is to navigate these two stages so that the overall tax rate on the liquidated shares is less than what it would have been if the clients were to have instead just withdrawn money from the retirement account on an as-needed basis, paying ordinary income taxes on all distributions.
Getting to Low or No Taxation
There are several ways to reduce that overall tax bill on the NUA shares both at the time of distribution and then when the shares are sold.
Start by only distributing the shares from the 401(k) that have the lowest cost basis. Note, not all employer plans will provide itemized share cost basis, and instead just give one total figure for the shares in question. In this case the clients should consider transferring only the dollar amount of shares on which they are comfortable paying income taxes, rather than the entire position. Since retirees are usually in a lower income tax bracket after retiring, the shares should (hopefully) be distributed in a tax/calendar year in which the clients’ other taxable income is little or nothing.
Then, the clients should attempt to sell the shares during years in which they have little or no other taxable income, so that they can qualify for the 0% rate currently imposed on long-term capital gains. Don’t forget that larger distributions of NUA shares and realizing big capital gains can spark hidden, unintended tax costs and consequences, such as disqualifying the clients’ from receiving Affordable Care Act subsidies for health insurance premiums. It’s a good idea to bring the clients’ tax preparer into the discussion for an analysis of the current and future potential tax ramifications of the NUA strategy.
Keep in mind that if clients choose to use the NUA strategy, they will have to completely liquidate the entire balance of the 401(k) within a single tax year. That balance can be moved to an IRA without any immediate tax consequences, but closing out the account also means that the clients will lose access to the investment options within 401(k) plan. Most of those options can likely be duplicated or emulated under your management, but stable value or capital preservation types of accounts will be almost impossible to find with self-directed IRA funds. Also, if you and the clients choose to hold onto the employer’s shares for any length of time, you may want to commensurately reduce the potential risk exposure in the clients’ other investment assets.
Kevin McKinley is principal/owner of McKinley Money LLC, an independent registered investment advisor. He is also the author of Make Your Kid a Millionaire (Simon & Schuster).