On This Episode
This episode takes a deep dive into Net Unrealized Appreciation (NUA), a little-known tax strategy that could significantly reduce taxes on company stock held inside a 401(k). John and Nick explain how NUA works, who it’s best suited for, and the key rules and timing considerations that can make or break the strategy. If you’ve accumulated employer stock and want to be more tax-efficient heading into retirement, this conversation will help you decide whether NUA deserves a closer look.
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Disclaimer: PFG Private Wealth Management, LLC is an SEC Registered Investment Advisor. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. The topics and information discussed during this podcast are not intended to provide tax or legal advice. Investments involve risk, and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial advisor and/or tax professional before implementing any strategy discussed on this podcast. Past performance is not indicative of future performance. Insurance products and services are offered and sold through individually licensed and appointed insurance agents.
Marc:
This week on Retirement Planning Redefined, we’re going to discuss net unrealized appreciation. If you don’t know what it is, stay tuned. Hey, buddy, welcome into the podcast. Let’s break down the conversation this week with John and Nick here on the show, as we talk about a topic that I guess tax strategies you might not be aware of. So the guys are going to help us out here a little bit with a topic that maybe doesn’t get as much attention or maybe people just aren’t realizing and understanding. I’m going to slide that right in there, unrealized. It’s the net unrealized appreciation tactic. So I guess, guys, we’ll dive in here in a second. Nick, you want to kind of set this up with what it is?
Nick:
Part of the reason that we wanted to talk about this is because we’ve been working with some clients over the past year where this was applicable. This isn’t something that we run across all the time. And essentially, it’s for somebody that is working for a publicly traded company that has the company stock inside of their 401k plan, sometimes also in like an ESOP, depending upon the structure of it, but has the company stock within the plan. Maybe they’re in a higher tax bracket and/or maybe they don’t currently have a good balance of non-qualified assets to qualified assets. And what net unrealized appreciation does is essentially a strategy that lets us extract the company stock out of the plan, out of the 401k plan and use capital gains tax rules versus ordinary income tax rules, is kind of the overview.
So for those, who does it benefit? Really, it’s somebody that works for a publicly traded company and wants to be able to take advantage of capital gains tax rules. Oftentimes the stock has appreciated substantially if they’ve worked there for a long time. And it’s a strategy that we found to be extremely effective in the right situation.
Marc:
Okay. All right. So that’s a good setup there. John, what’s the mission today with the podcast? Just to try to explain this a little bit better for folks?
John:
Yeah. As Nick mentioned, this has come up and we’ve noticed that clients, some aren’t aware of it at all, or if they are aware of it, they don’t really understand how it works or how to do it. So we decided, hey, let’s kind of do a deep dive into this and explain it to our listeners, that maybe they have the stock in their plan and they’re not aware of this. And maybe it’s going to raise some questions, where, “How can I be tax efficient and does this work for me?” So we’ll go through some details of, as Nick just mentioned, what it is. We’ll dive into that, give you some examples, who it benefits, who it doesn’t benefit. So the whole goal of today is try to unpack this as best we can.
Marc:
Well, can you give us an example? Maybe that’ll help highlight that a little bit.
John:
Yeah. So as Nick mentioned, this is a stock that you have in your employer plan. And what the net unrealized appreciation is, so short, you’re going to hear us say NUA for short. As you start to say that word, that phrase more and more, it’s kind of a tongue twister it’s turning into for all of us. But what that is, it’s growth on your money or growth on the stock above what your cost basis is. And your cost basis is your contribution to that stock. So an example would be, let’s say you have a company stock and you’ve put $50,000 into it. So your contribution to that stock is 50.
Over the years, you’ve had some appreciation. Now that stock, when you get your statement, it’s 250,000. So your basis is 50. The stock total value is 250. So your NUA is 200,000, the appreciation above what your cost basis is, and this example is 50. So how that gets treated is when you do this, and Nick’s going to talk about some triggering events and how you qualify to do it. But one of the things you need to understand is when you do this, you transfer the money out and Nick’s going to go over how that happens, but the $200,000 NUA will be treated as long-term capital gains. You don’t pay taxes on that 200,000 until you sell it, which is one of the benefits. And we’ll dive into when that makes sense and how you do it.
The 50,000, whenever you transfer it out, is taxed immediately. So that will be considered part of your ordinary income taxes. So let’s say you do this in 2025, in this example, you take out the 250, the 50,000 will be immediately considered taxable income in that year. So it’s very important that if you do this, you time it correctly and you make sure that you do in a year where maybe your tax is a little bit lower or you need that money anyway, so you might as well just do it.
Marc:
Gotcha. Okay. So Nick, what are those requirements then?
Nick:
There’s essentially a triggering event. So the four triggering events to be able to execute the NUA would be attaining age 59 and a half or retirement or separation from service, total disability, or the last one is death of a shareholder. So one of those four trigger events allow you to take advantage of the rules in the way that John kind of laid it out. And one important thing to note is that you’re only able to do it one time per each of those triggering events. So this isn’t something, I think the key takeaway, and this isn’t a tutorial on exactly how to execute it properly. This is an overview to introduce the concept to help you understand that, hey, if you do work for a company that has publicly traded stock and you hold it in your 401k, you need some help to talk to people, because there’s a lot of nuance to it.
Marc:
Sounds like it.
Nick:
And so, yeah. So if you do attain one of those triggering events and you are looking to execute it, you would do what’s called an in kind transfer. So essentially you are transferring the stock out of the plan into a brokerage account in kind. So you’re not selling anything. You don’t want to sell it inside of the plan. That’s really kind of the key takeaway for people is if you go ahead and do a reallocation in your 401k, because for whatever reason you want to make this a change inside of the 401k and you shift that money out of the company stock, you’re losing track of your cost basis and you’re reducing the benefits of the anyway. So you do the in kind transfer and it has to be done as a lump sum from a distribution standpoint. So the entire balance that’s inside of the account needs to be transferred out.
So again, there’s a lot of nuance to this and how it needs to be done, and timing on making sure that these things happen in the proper tax year, which are all things that we can help you with, but it is something where the tax benefits can be substantial and can allow you to then diversify that concentrated position outside of the account and use capital gains rules versus ordinary income rules.
Marc:
So kind of a summary on that, right? What’s an easy summary for people to think of?
John:
In summary, how this works, and Nick mentioned, you have the triggering event, which allows you to do this. Then as far as doing it in kind transfer of the stock itself, and as far as the lump sum distribution that Nick mentioned, let’s say you have the company stock and then you have some other investments outside of that. When you clear those out, those have to get out of the account, as he mentioned, and your options, the best options typically are you want to roll that into an IRA or another employer plan, so you don’t get taxed on that amount.
Marc:
Gotcha.
John:
So if you’re going to do something like this, work with a professional, work with an advisor, a CPA, or someone at the plan that knows what they’re doing, because we have had conversations with some employees that are like, “Huh, what’s that? What are you talking about?”
And it’s like, “Let me talk to your manager real quick.” So when the account’s cleared out, the stock goes to a taxable account and everything else, best practice is typically to go into another retirement plan, but it has to be cleared out.
Marc:
Okay. So I mean, a lot of people may be listening and going, “Okay, this sounds a little complicated,” so to the point of talking with somebody, but they’re also probably thinking, “What’s the real benefits here? What’s the benefits to me?” So John, can you highlight some benefits for us?
John:
Yeah, so we’re looking at one of them, and the big one is the tax rate conversion. So as Nick mentioned in the intro, what we’re doing here really is we’re having that stock be taxed as capital gains versus ordinary income. And now this doesn’t work for everybody, so it’s important to look back at your plan, but ordinary income tax, depending on your bracket, it could be 20% or higher. Again, we don’t know until you pull the money out and this is where proper planning is required, but with long-term capital gains rate, it could be zero, 15 or 20. So the tax rate conversion is a big deal. And to find out if this makes sense for you, you should know how the plan looks and where you’re at. And the next benefit would be the deferral. So when it transfers out, you have the option of when you sell it.
Well, depending on if you don’t need the income for that particular holding, but you can kind of control when you sell it. So if you have a year where your income’s pretty low and you look at it and say, “Hey, I might be able to sell this and have 0% tax rate.” You can do that, or maybe it’s 15, but you have the deferral aspect and a little more control to say, “Hey, I’m going to dictate when this actually gets sold to lower my income taxes.”
Marc:
Gotcha. Okay. So Nick, what’s some other things here for benefits?
Nick:
One of the things is conceptually, and one of the scenarios that we had to run into with a client is they had a substantial amount of money in their pre-tax accounts. So when we looked at the withdrawals that they were going to have to take in retirement, once they were eligible for the RMDs, that amount was substantially higher than they needed to take, which was really going to bump them up. So our thought process was let’s reduce the qualified bucket per se, which will then allow us to reduce the RMD as well, and take better advantage of having a more balanced overall kind of nest egg. So being able to lower those potential RMDs in retirement’s a big deal. And then I would say from the standpoint of from an estate tax perspective, anytime you are now with the changes that happen in SECURE Act 2.0, when somebody inherits qualified funds, pre-tax retirement funds, they have to withdraw those funds over a 10-year period.
So if it’s a non-spouse and let’s say that they’re in a good tax position, being forced to withdraw a substantial amount of money over a 10-year period could really change their overall tax perspective like, hey, yeah, obviously it’s money, but the goal is to pay the least amount of taxes as possible. So the benefits of the provision in brokerage accounts, which is a step-up in cost basis on a holding like this could be substantial. So from an estate planning perspective, that’s also a very good way to be able to manage it and take advantage in why this can be beneficial and helpful for somebody.
John:
So one more actually tax benefits of this, and we don’t see this too often with the way the market’s been lately with all the gains, but we run across some people that have some carryover losses, and this could be a great way to offset some gains with those carryover losses. Again, we are not tax advisors, so meet with your tax advisor when you’re kind of doing some of this planning, but we could definitely help guide clients and ask the right questions to their CPA or accountant.
Marc:
Okay. All right. Yeah. So as always, any financial vehicles, especially when you’re not used to, you certainly want to get guidance along the way. So let’s kind of finish this off guys with a who does it work for and maybe who shouldn’t be doing it, right? So whoever wants to start, give me who does it work for kind of idea.
Nick:
Yeah. So I would say we tend to look at things a lot of times from like a two-part decision-making process. So number one, your radar should go up big time, if you are somebody that works at a publicly traded company that allows you to invest in the company stock in the 401k plan. That is the number one reason to evaluate it. And then if you fall into that bucket and you have been somebody that has been consistently investing for a long time into that company stock, and you have a substantial position in the plan, which we do see quite a bit happen, especially somebody that really believes in the company and they’ve been able to kind of take advantage of it, figuring out what the cost basis is, so how much you’ve invested over time and understanding the gap between that cost basis and what the true value of that holding is, especially with the substantial run up in the market over the last 10 years, that is another thing to kind of take in mind and consider.
And then, if you are somebody that maybe doesn’t have much balance in your overall nest egg from kind of like your buckets or account types, so maybe you’re very heavy and all your money’s in pre-tax, and you haven’t saved much money in non-qualified accounts, and that this is a way to immediately create a bucket of non-qualified money, that’s also a situation that would be very beneficial for somebody.
Marc:
Okay. So then John, I guess give us some people who maybe don’t want to consider doing this, right?
John:
Yeah. So let’s say we talked about this being a portion of your retirement plan. Let’s say it’s 80% of your retirement assets, then you might want to look at this and say, “Hey, that might be too much to really do this with.” So if you have a high concentrates in that stock, it might be prudent to diversify it.
Marc:
Gotcha.
John:
So you want to take a look at what’s your situation and although it’s great to avoid taxes, you don’t want to just completely focus on that and not be prudent, and especially going to retirement, where you need these funds to live off of. So with the cost basis, you wouldn’t want to do it or it might not make sense to do it if your cost basis is high. So in that example where the 50,000 was the person’s cost basis and the account value is 250, let’s say your cost basis is 200,000. I would consider that high in reference to the account balance being 250. So in that situation, it might not be the best strategy, because there’s really not a ton of tax savings when you look at the overall picture, and actually you might be creating a bigger tax bomb if you do that transfer and all 200,000 is taxable in that given year.
Taxes make your situation, depending on taxes, how much money you need, death benefit, beneficiaries, it’s all part of the puzzle of what makes sense for you to do. And we always say this, it goes back to the plan. Does it make sense for your situation? If it does, this can be a really amazing tool to use. If it doesn’t, it’s good to do your due diligence to make sure is it a benefit for me.
Marc:
Gotcha. So like any financial vehicle, right? Look at the plan, your timeline, what makes sense, your tax strategy, all those kinds of things, and work with somebody to pull this stuff together. So if you’ve got some questions around this, and you probably do, make sure that you’re reaching out to John and Nick for a more detailed conversation about your specific situation at pfgprivatewealth.com. That’s pfgprivatewealth.com. And don’t forget to subscribe to the podcast on Apple, Spotify, or whatever app you enjoy using. Guys, that’s going to wrap it up for us here. So thank you so much for tackling this one. I’m sure we’ll get some questions or we might even have to do another dive into this a little bit, just because it is an interesting topic that doesn’t maybe get as much conversation. So Nick, thanks for hanging out and breaking it down, my friend.
Nick:
Yeah, no problem.
Marc:
All right. And John, thank you my friend for hanging out and talking with us. We appreciate the time as always. For John and Nick, I’ll catch you next time here on the show. This is Retirement Planning Redefined.