If you hold significant amounts of appreciated company stock in your employer’s profit sharing or 401(k) plan, you could be hit with a huge tax bill when you decide to withdraw that stock from your plan.
However, if you plan carefully, you could significantly lower these tax consequences by taking advantage of the IRS’s Net Unrealized Appreciation (NUA) and Net Unrealized Depreciation (NUD) rules.
NUA—A strategy for minimizing investment profits
The NUA rule can help you reduce the tax impact of taking distributions of company stock that have risen significantly in value.
Here’s how it works.
When you leave your company or retire and withdraw company stock shares from your qualified plan, only their cost basis, (what you paid for shares, or the share price when you were awarded shares), rather than their higher current market value, will be used to calculate taxes.
The distribution will be taxed as long-term capital gains, rather than as ordinary income, and will not be subject to early withdrawal penalties (if you take the distribution before age 59½) or the 3.8% Medicare investment tax surcharge.
For example, if the cost basis of your shares is $10,000, and their current market is $50,000, you’ll only pay capital gains taxes on the original $10,000 when you remove them from your account.
An “all-in” proposition
To take advantage of the NUA rule, you must take a lump sum distribution of the entire value of the qualified account within the same calendar year when you change companies or retire.
In other words, you must withdraw all of the assets in your 401(k) account, not just your company stock shares.
You might be thinking, “If I take this lump sum distribution, won’t I have to pay taxes on the entire value of my account, including the mutual funds I’m also invested in?"
Fortunately, the answer is “not necessarily.”
The only taxes you’ll have to pay immediately are the capital gains taxes on the NUA value of your company stock if you meet certain conditions (discussed below).
You can roll over the rest of your distribution into an IRA or transfer it to your next employer’s 401(k) plan. If you transfer these non-company-stock assets directly from your old employer’s 401(k) plan to another plan or IRA custodian, you won’t have to pay taxes or penalties on the distribution.
Two key caveats
There are two important points to remember if you want to take advantage of the NUA rules:
- The company stock distribution must be in the form of "certificate” shares. If you sell your stock shares in your 401(k) and then take a distribution, the proceeds will be based on their current market value, not their NUA value, and this amount will be taxed as ordinary income if you don’t roll them over into another 401(k) plan or IRA.
- After the distribution, you must transfer your company shares into a separate taxable brokerage account. If you roll over those shares directly from your plan to another 401(k) plan or IRA, their cost basis will be reset to their current market value on the day the transfer occurs.
While taking advantage of the NUA rules can be a sound strategy for managing the tax consequences of company stock distributions, it can be even more effective during down markets when combined with the Net Unrealized Depreciation (NUD) strategy.
NUD—Capitalizing on losses
If the current value of your company stock has spiraled far below what it was originally worth, now may be a good time to take advantage of the NUD rules. They’re designed to help investors reduce the cost basis of their shares.
Here’s how it works.
You can sell the company stock shares in your account and then immediately repurchase them at a lower price. This effectively “steps down” their cost basis. And you don't have to worry about the the IRS's "wash sale" rules--they don't apply to these kinds of transactions.
Then, if you later decide to take advantage of the NAU rules when taking a lump sum distribution from your account, the long-term capital gains taxes you’ll need to pay on this stepped-down amount should be less.
If the price of your shares continues to fall, you can sell and repurchase shares over and over to step down your cost basis over time. Keep in mind, however, that you must hold on to those shares for at least one year before you use the NUA strategy for them to qualify for more favorable long-term capital gains tax treatment when you take your lump sum distribution.
Of course, taxes aren’t the only thing you need to think about when considering what to do with your company stock. For example, if most of your 401(k) plan assets are invested in company stock, it might be prudent to sell some shares and invest the proceeds in other investment options to diversify your portfolio and reduce risk.
As these decisions involve weighing both your tax and investment priorities, you may want to meet with a tax professional and financial advisor before you make a move.
This material has been provided for general informational purposes only and does not constitute either tax or legal advice. Although we go to great lengths to make sure our information is accurate and useful, we recommend you consult an accountant or professional tax preparer or advisor.
This article was authored by Dan Flanagan and Jeffrey Briskin. Dan is a financial advisor and Partner located at Canby Financial Advisors, 161 Worcester Road, Framingham, MA 01701. He offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser. He can be reached at 508.598.1082 or email@example.com. Jeffrey Briskin is Director of Marketing at Canby Financial Advisors.
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