In the world of retirement planning, there is a hidden gem to create substantial income tax savings: Net Unrealized Appreciation (NUA). It is a clunky term, but behind it lies a powerful strategy that can transform the financial landscape for those with company stock in their employer-sponsored 401(k) plans.
At Alison Wealth Management, we have witnessed firsthand how NUA can be the key to unlocking substantial tax advantages. In this blog post, we will delve into the intricacies of NUA, explore its potential benefits, and share a real-life success story of a client that reaped substantial tax savings by working with our team on their retirement, investment, estate, and charitable giving plan.
Let us start with the basics:
If you hold company stock within your 401(k), it is considered pre-tax money. This means that when you eventually withdraw it, you will owe income taxes on the entire amount. If you pass away with a pre-tax 401(k) or have rolled your 401(k) into an IRA and pass away, your non-spouse beneficiary must deplete that inherited retirement account within 10 years.
This creates a tax time-bomb for your beneficiary, who will be forced to pay tax on the distributions at whatever income rate they are at. This could easily cause 30 percent to 50 percent of your retirement account to go to taxes.
NUA refers to the difference between the original cost basis of the company stock (what you paid for it) and its current market value. It’s the appreciation in value since you acquired the stock.
How does an NUA rollover strategy work?
Instead of rolling over your entire 401(k) balance into an Individual Retirement Account (IRA) upon leaving your job, you can take advantage of NUA by:
- Transferring the company stock directly to a taxable brokerage account.
- Pay ordinary income tax only on the original cost basis (not the appreciation).
- When you eventually sell the stock, you will pay capital gains tax on the NUA portion (the appreciation) at the more favorable long-term capital gains rates.
Why consider an NUA rollover strategy?
- Immediate Tax Savings: By paying income tax only on the cost basis, you avoid higher tax rates on the entire amount.
- Long-Term Capital Gains Treatment: The appreciation (NUA) is taxed at potentially lower rates than ordinary income.
- Estate Planning: If you leave the stock to heirs, they receive a step-up in basis, potentially reducing their tax liability.
But NUA rollover strategies are not for everybody, and there are specific qualifications and considerations one must navigate to determine if it is right for you. In addition, NUA is generally a once-in-a-lifetime opportunity based on the stringent rules, and it is irreversible so you must ensure you execute correctly.
We highly advise professional tax & wealth management guidance in navigating the potential for an NUA rollover. Click here to schedule a complimentary call with one of our advisors at Alison Wealth Management to see if this is right for you.
Take Walter, a 72-year-old retiree from a major publicly traded oil company. Upon completing a discovery meeting with Walter and his wife Susan, we learned that Walter had amassed $12,000,000 of pre-tax money in his 401(k), Susan had $750,000 of IRA assets, and they had a living revocable trust brokerage account with $2,500,000. They were collecting Social Security Income of about $61,000, had $100,000 of dividend & interest income from their portfolio, and a pension of approximately $110,000. This $271,000 of income covered most of their living expenses, so they were not even tapping into the $12,750,000 of pre-tax retirement assets they had accumulated.
Walter and Susan had three primary concerns:
- Walter was a year away from having to start taking his required minimum distributions from his pre-tax retirement accounts, which we estimated to be about $480,000. This annoyed Walter because he did not need this money to cover their current spending, but he was going to be forced to take these distributions…and pay tax at the top brackets…whether he likes it or not.
- Walter and Susan have a 25-year-old son still living at home. In Walter’s words, his son “failed to launch”. Walter and Susan would not feel comfortable with Sam getting full access to the money if something were to happen to them.
- Walter and Susan recognized that they had more than enough money to support their retirement and help supplement an income for Sam throughout his life, so they wanted to start giving money away, both to charities as well as family members in need.
Upon our discovery meeting's conclusion, we determined we were a good fit to work together and formalized our engagement. We met a few days later to begin designing their plan, and upon our deep dive into their current assets, we learned that Walter’s 401(k) held $8,000,000 of company stock and $4,000,000 of diversified mutual funds.
This triggered us to have the NUA discussion.
The first thing we did was look at whether an NUA rollover strategy made sense for Walter and Susan based on the cost basis of the stock in the 401(k) plan.
We learned that the company stock had 4 segments to it due to acquisitions over the last 25 years.
- Segment 1 had a cost basis of $20,000 with a market value of $585,000
- Segment 2 had a cost basis of $1,400,000 with a market value of $3,755,000
- Segment 3 had a cost basis of $68,000 with a market value of $900,000
- Segment 4 had a cost basis of $537,000 with a market value of $2,760,000
In addition, Segment 2 had pre-1987 and post-1986 basis of $428,000.
We discussed this with Walter and Susan and agreed it was an easy decision to do an NUA rollover strategy on segments 1 and 3, as they had low basis and lot of appreciation (NUA).
For example, if we only did an NUA rollover strategy on those two segments, we would move $1,485,000 ($585,000 from Segment 1 and $900,000 from Segment 3) into a taxable account and would pay ordinary income tax on $88,000 of income ($20,000 basis from Segment 1 and $68,000 basis from Segment 3). At a 24% marginal tax bracket, this equated to about $22,000 in federal tax. This shifts all that appreciation ($1,397,000) from being taxed as ordinary income rates, which today is a top rate of 37% federal and scheduled to increase to 39.6% at the end of 2025, down to a top 20% federal long-term capital gains tax rate plus a 3.8% net investment income tax. This is a federal tax savings of 13.8 percent to 15.8 percent, or over $200,000. After the NUA rollover, this $1,485,000 would not be in the pre-tax IRA, so it would lower Walter’s RMD at age 73, which he really liked.
The next step was to determine if we should also include Segment 2 or 4 in the NUA rollover strategy. Since Walter and Susan wanted to provide annual gifts to charity each year while they are alive, plus bequest some charities upon their passing, we wanted to leave some of the money in the pre-tax IRA to help achieve our charitable giving goals. For example, Walter and Susan can use a strategy called a qualified charitable distribution to give up to $100,000 from each of their IRAs to charity each year. Once they are 73, this charitable distribution will also help reduce their taxable RMD. In addition, if Walter and Susan both pass away and name charities as the beneficiaries of the IRA, the charity does not have to pay tax. This makes pre-tax IRA money very efficient for charitable giving.
But pre-tax IRA money is horrible for wealth transfer to non-charity beneficiaries in most instances. For example, in our meeting we discovered that if something happened to Walter and Susan, all their money would flow into their living revocable trust, which was established for the benefit of their son Sam. We reviewed that trust document, and it stipulated that at age 25 Sam would be entitled to 50% of the assets and at age 30 he would be entitled to the remaining 50%. Susan shared that they established this trust 20 years ago, long before they had accumulated this type of wealth, and there is no way they are ok with Sam getting access to a lump sum of over $7,000,000 at the age of 25 if they were to pass away. They chuckled and said he wouldn’t make it to age 30 if he got $7,000,000 today.
This meant we would need to revise the type of trust that Walter and Susan establish for the benefit of Sam. We wouldn’t want a trust that just gave Sam unfettered access to the money, but rather a trust that could accumulate money and appoint a professional trustee that could distribute supplemental income to help cover the health, education, maintenance and support of Sam, at least until he proves that he is responsible and competent to handle that type of money.
When funding a trust like this, a retirement account is one of the worst assets you can leave to a trust. Retirement accounts have something called income in respect of descendent (IRD) when you pass away and leave that account to a non-spouse beneficiary. When you pass away and leave that account to anyone other than your spouse or certain eligible beneficiaries, the beneficiary must deplete the IRA within ten years.
When leaving IRA assets to a trust that is going to hold those assets for the benefit of a beneficiary, the distributions from the inherited IRA which are accumulated and reinvested in the trust will be taxed at the highest federal tax rate, which is 37%, heading up to 39.6% at the end of 2025. There is a substantial difference between the taxation of assets in a trust compared to the taxation of assets held individually. For example, once a trust has taxable income over $15,200, the trust will be in the highest marginal tax bracket of 37% in 2024 versus if you were married filing jointly you could have income of over $731,000 before you hit that top tax bracket.
So, in Walter and Susan’s case, the money from the IRA that would have been held in trust for Sam would have been eroded by taxation of the trust assets.
Contrast that with leaving a non-retirement account, such as company stock in a taxable account, to an accumulation trust. The trust can inherit the assets tax free, as the trust will receive a step up in basis at the death of Walter and Susan. From there, the trust can make much more tax efficient distributions to Sam throughout his lifetime. This is a huge tax savings to the family.
In addition, because Walter and Susan wanted to start giving away some of their money while they are alive, we wanted a good balance of money out of the retirement accounts. Gifting appreciated assets, such as company stock, is much more tax efficient than taking withdrawals from an IRA at the highest marginal tax brackets and gifting the cash to family.
That said, we increased our NUA transaction and included Segment 4 for $2,760,000 of market value with a cost basis of $537,000.
This gave Walter and Susan $4,245,000 of company stock value rolling over from Walter’s 401(k) to his taxable brokerage account. This $4,245,000 had a cost basis of $625,000. That cost basis would be taxed as ordinary income. We would then rollover the $4,000,000 of mutual funds and $3,755,000 of Segment 2 company stock into Walter’s pre-tax rollover IRA to continue to defer taxes.
But wait, there is one more complex wrinkle that adds incredible tax benefits. With Segment 2, there was pre-1987 and post-1986 basis of $428,000. This was money that went into the 401(k) as an after-tax contribution. This meant that we could set up a Roth IRA and roll that basis of $428,000 directly into a Roth IRA at no tax cost. This would allow that $428,000 to continue to grow tax deferred and be tax free to Walter and Susan for withdrawals or tax free to Sam’s trust upon the passing of Walter and Susan.
After this rollover transaction, Walter and Susan ended up with:
- IRA Assets of $8,077,000
- Taxable Assets of $6,745,000
- Tax Free Assets of $428,000
By executing the NUA rollover strategy, we greatly decreased their RMD for life and established a tax efficient inheritance account to fund a trust for their son's benefit. It will allow us to use those RMDs to execute annual qualified charitable distributions, further lowering their tax liability in retirement. It provided them the ability to execute an annual gifting plan to family members using highly appreciated stock for maximum tax efficiency. We unlocked over $428,000 of money that could be rolled over into a Roth IRA for tax growth and tax-free withdrawals or inheritance. Lastly, if Walter were to pass away, his family would not have to pay any tax on the net unrealized appreciation of the company stock because it is now held in a taxable account that is eligible for a step up in cost basis.
This whole strategy costs less than $150,000 of federal income tax but will yield tremendous long-term lifetime tax savings.
There is a lot more strategic planning to be done with Walter and Susan, but the morale of the story is that if you have company stock or a large 401(k) or IRA, you need to work with a holistic tax & wealth advisor to ensure you maximize the benefits to your family and charity while minimizing your lifetime taxes.
Click here to schedule a complimentary call with one of our advisors at Alison Wealth Management to see if this is right for you.