If you work for a corporation with publicly traded stock, it's likely you own some of that stock in your 401(k) plan. If you do, it's crucial you understand the rules for net unrealized appreciation.

What is net unrealized appreciation? It's the unrealized gain accumulated in your company stock while you own it in your plan. Unrealized gain means the amount the stock price has increased over the amount you paid for it.

Let's say you have 100 shares of your company's stock that you paid $50 a share to buy, making your cost $5,000. The stock is now selling for $100 a share, bringing the value to $10,000. Your unrealized gain is $5,000. In other words, you haven't sold the stock and “realized” or received the gain.

If you hold shares of stock outside a 401(k), whether in an IRA or a taxable account, the term used to describe the gain before you sell is unrealized capital gain. When the stock is from the company where you work and in your 401(k), it's called net unrealized appreciation and has special rules attached to it.

As you know, the IRS rules are rarely simple. The regulations for net unrealized appreciation are no different.

As long as the stock remains in the 401(k), you owe no taxes on it. The rules come into play when you leave the company and decide to move your 401(k) plan.

It's this circumstance, along with a couple of others, that trigger the rules on the net unrealized appreciation of company stock. It's critical you understand them. If you make the wrong decision, it could cost you tens of thousands of dollars in taxes.

Here's what you need to know.

Disclosure:

This information is provided for general information only and is not intended as personalized investment advice. This presentation is not intended to be any form of financial planning, investment, tax or legal advice. There is no substitute for individualized investment advice, and no conclusions should be drawn from this information. All readers should contact their professional investment, legal and tax advisors before entering into any investment or investment agreement.

Basics of Net Unrealized Appreciation (NUA)

I offered some of the basics of NUA in the introduction. Assuming you own company stock in your retirement plan, the gain in that stock while in the plan is called net unrealized appreciation.

Stock in a taxable account

Were you to own your company stock in a taxable investment account (individual, joint, trust, etc.) and decide to sell it, the profits get taxed based on how long you've owned the stock. If you've held it for less than one year, the IRS considers that a short-term holding period. As such, they tax those gains at your ordinary income rates. If held longer than one year, the IRS considers that to be long-term. Long-term capital gains tax rates are lower than short -term rates. Depending on your income, they are either 15% or 20%.

Here are the 2019 income tax and capital gains tax brackets and rates:

Source: Forbes

You can see the saving when comparing the two charts. For a married couple filing a joint return making $50,000, a short-term capital gain gets taxed at a blended rate of 11.2% (the first $19,400 @10%, the next 30,600 @12% gives a blended rate of 11.2%). If the gains were long-term (>12 months), there is no tax due.

The higher the income, the greater the tax savings become.

Stock in an IRA

When you own stocks (other than your company), mutual funds, or ETF in a traditional IRA, the tax rules are different. For this discussion, we will assume that all of the money in the IRA is pre-tax. In other words, you have never paid tax on the money in the IRA. You owe no taxes on investments sold at a profit while those investments remain in the IRA. Any money taken out of the IRA gets taxed at ordinary income tax rates (see schedule above for rates).

In a taxable investment account, the money invested is after-tax money. In other words, you've already paid taxes on the money before putting it in. As such, when you sell, you don't pay taxes twice. You're only paying on the gains in the investments. That's where the long-term capital gain benefits come into play.

Tax rates

Since you've never paid taxes on money put into the IRA (all deposits are pre-tax), the IRS assesses the tax at ordinary income rates on ALL of the money withdrawn. The IRS giveth. The IRS taketh away. Think about it. The IRS offered you the opportunity to get a tax deduction for money you put in every year. They've sacrificed current tax revenue to provide that benefit. They're going to recoup that lost tax revenue when you withdraw money from the IRA.

And remember the required minimum distributions (RMDs). At age 70 1/2, the IRS requires you to begin taking a distribution on your IRAs based on their uniform life table. With the growth of the account, the amount of tax the IRS receives via RMDs could be much higher than the annual deductions. Of course, if the account value drops due to market condition, the tax would be lower.

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Company stock in a 401(k) plan

Let's set up an example to highlight the options.

John Doe worked at XYZ Company for the past twenty years. Each year, the company contributed XYZ stock to fund their matching contribution (a common practice) to John's plan. To keep the math simple, we'll say that the cost of John's XYZ shares is $200,000. The stock is now worth $1,000,000, making the gain $800,000. John decides to retire and wants to move the money in the 401(k) plan to his own IRA. Sounds like a reasonable thing to do, right?

If John transfers all of his 401(k), including the company shares to his IRA, when he withdraws money, the taxes he pays will be at ordinary income tax rates. Were he to decide to take a lump sum distribution, he would owe taxes on the full amount for the year in which he took the money. Taking the distributions over his life means paying taxes only on the amount he withdraws each year. But the tax rates applied are at the ordinary income tax rates at the time of the withdrawals.

Net unrealized appreciation requirements

The benefit of owning company stock in your 401(k) plan is you get the opportunity to have long term capital gains rates applied to the stock when sold.

First, John must have a valid “triggering” event. There are three:

His death – In this case, John's beneficiaries can take advantage of the NUA rules when transferring his account. Reaching age 59 1/2 – If John doesn't separate from service (leave his employment), whether he can take advantage of the NUA rules depends on his plan's rules. If they allow him to make in-service withdrawals (take out money while working), he may be able to take advantage. If not, he'll have to wait. Separation from service – If John gets fired, retires, or leaves the company for any reason, he can take advantage of the NUA rules (even if not 59 1/2). The rule does not apply to the self-employed.

The NUA process

If John leaves the XYZ company, here's how he can take advantage of the NUA tax break.

First of all, the distribution must be a full distribution. If you have other investments besides the company stock (highly likely), you can't transfer the company stock and leave the rest of the investments intact — you must distribute the entire account value.

We' ll assume John has $1,000,000 in XYZ stock in his plan plus another $500,000 that are not XYZ shares. The process goes like this.

John would open two accounts, one taxable and one IRA (or use existing accounts if he has them). In the taxable account, he would transfer the shares of XYZ stock IN KIND. An in-kind transfer means the shares of stock would transfer to the new taxable account. He should not sell them in the IRA before transferring.

The other investments in the plan would transfer to the IRA account. This is a trustee to trustee transfer and has no tax consequences. He can sell the securities and move cash or transfer the securities in-kind. John would make that decision based on whether he likes the funds he owns and wants to keep them or sell them and buy different funds.

Before selling, John needs to calculate the costs to sell. If it's cheaper to do it before transferring (usually is), then he can move the cash. Otherwise, he can transfer the securities and sell them in his IRA.

NUA tax savings

Tax savings are where John gets the most benefit. When he transfers his shares of XYZ to a taxable account, here is how the taxes work.

He will pay tax on $200,000 (his cost) for the year in which the transfer takes place. He will pay that tax at ordinary income tax rates. The $200,000 gets added to his other income to determine the rate. See the table below for details.

The remaining $800,000 is tax-deferred. In other words, no tax is due when after the transfer. Should John decide to sell some or all of the stock in the first year after moving it, the gains get taxed at the favorable long term capital gains rates.

Here are the numbers:

[table id=18 /]

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Tax comparison

To illustrate the savings, here's an example computing the tax on a full distribution of the $1,000,000 in cash versus selling the XYZ shares in a taxable account after transferring. We will use the 2019 tax tables for reference. We will assume the capital gains tax rate is at the higher 20% rate.

John would pay ordinary income tax on the full $1,000,000 distribution. Assuming he's married filing a joint return, here's how that works.

[table id=17 /]

The NUA advantage amounts to a savings of $111,701! That's a significant number. Granted, it's highly unlikely that John would distribute the $1,000,000 in a lump sum. It's also hard to calculate and compare the taxes he might pay over his lifetime on the value of the XYZ stock in his IRA over years of distributions.

The point of the exercise is to introduce you to the benefit of separating your shares of company stock into a taxable account when moving your 401(k).

Note: We're not calculating any other income to compute his tax rate. The examples are to illustrate the difference between taxing the entire account value at ordinary rates versus the benefit of using the NUA rule.

Other things to consider

RMDs

The only way to take advantage of NUA is with a complete distribution. If you are working past age 70 1/2, have company stock and decide to retire, your RMD's can get you into trouble.

Let's say you chose to retire in 2018 at age 72. Once you stop working, your RMDs begin. You have one due for 2018. If you took that one in 2018, transfer your account in 2019, assuming you could separate the company stock, you wouldn't get the NUA tax break. Why?

The requirement is you must take a full distribution in one tax year. Since you took an RMD in 2018 and initiated the transfer in 2019, you've violated that rule. That makes the entire account value subject to ordinary income tax rates upon distribution.

Gain on the stock after transferring

If you did everything right by moving your account in one tax year and separating the company stock into a taxable account, you've maximized the tax benefit available. What happens to the gains in the stock going forward if you don't sell? In that case, the gains on the stock going forward follow the general rules of long-term capital gains treatment. That is, stock held more than one year that you sell would qualify for long-term capital gains rates.

Using the example of John and his XYZ stock, let's assume the stock went up another $100,000 during the next year. If John waited to sell until he'd held the stock after one year, that $100,000 gain, along with the original $800,000 would get taxed at long-term capital gains rates.

Or if he sold it all before the first year was complete, he still gets the long-term capital gains rate on up to $800,000. Assuming John sold some, but not all of his shares before one year, on those shares, he would pay the long-term capital gains rate. However, any subsequent shares sold during the first year get taxed at ordinary income tax rates.

Final thoughts

As you can see, there are many things to consider when transferring a company retirement plan in which you own company stock. Like many things with tax rules, mistakes can be costly. Understanding the rules before deciding can save you tens of thousands of dollars. Be sure you look at all of your options before transferring your company 401(k) plan.

The NUA decision is nuanced. The younger you are, the more analysis you should do. The initial tax bill for the cost basis can be high. Moving the stock to an IRA, selling it, and diversifying may offer greater growth opportunity for the money than taking advantage of NUA. Careful analysis on both sides will help you make the best decision.

Retirement planning, like financial planning in general, is a dynamic process. Circumstances change during life. There are job changes, deaths, divorce, and health issues that can change our plans pretty quickly.

I hope you see from this post how important it is to know your options when you bold company stock in your 401(k). In the above example, taking advantage of the net unrealized appreciation benefit saved John over $100,000 in taxes. Keeping that money invested and growing it at a reasonable rate of return would add to his retirement nest egg.

And who doesn't want more money in retirement?

Now it's your turn. Do you own company stock in your 401(k)? Did you know about the NUA option?