This post was authored by Salvatore M. Capizzi, Dunham's Chief Sales & Marketing Officer. If you have questions concerning today's topic, please call us at (858) 964 - 0500. Hold us to a higher standard.

What if you could convert ordinary income for a portion of a 401(K) rollover to capital gains?

Would that have a benefit?

This may be possible through application of Net Unrealized Appreciation (NUA). This is not a widely used or, for that matter, a widely understood concept, which at times results in the rollover of a 401(K) in a most tax inefficient manner.

Net Unrealized Appreciation may provide favorable tax treatment on employer stock for lump-sum distributions from a qualified retirement plan. NUA is the difference of the current value of the stock in the 401(K) less what you actually paid for the stock in your 401(K) (average cost basis).

Using NUA, you can convert the taxes on the gain of the stock in the 401(K) from ordinary income to capital gains, which may result in a meaningful tax savings.

As with many tax situations, there are things you need to know. The three important requirements for meeting the NUA rules:

  1. Must be a lump sum. Distribution of your entire account balance must occur in the same calendar year. You cannot simply transfer the stock.
  1. Must be in-kind distribution. You must transfer shares, not cash.
  1. Must be done after a triggering event such as death, disability, separation from service, or reaching age 59 ½.

Let us systematically look at some of the things you need to know about a NUA.

Thing to Know Number One: Tax on the Gain of the Company Stock

Let us examine a hypothetical situation.

Mary is retiring from a company that offers a 401(k) plan where she can purchase company stock. Over the years, she contributes $150,000 to the plan in which she uses to buy her company’s stock. This stock has significant growth over the years and is now worth $750,000. In addition, she has $250,000 in a diversified portfolio of mutual funds.

If Mary rolled the entire amount into an IRA, the taxation of the full $1 million is ordinary income whenever Mary takes a distribution or receives her RMDs.

However, in Mary’s hypothetical situation, the NUA would be $600,000, arrived at by taking the current market value of $750,000 less her basis of $150,000.

This means that taxation of the $600,000 gain could be at a lower capital gains rate rather than a higher ordinary income rate.

Thing to Know Number Two: Tax on Mary’s Basis

Mary’s basis, the $150,000 she used to invest in the company stock in her 401(K), went into her plan as pre-taxed dollars, meaning, she never paid taxes on that money. Therefore, the taxation of the basis will still be the ordinary income tax rate in the year of the distribution and subject to the 10 percent early withdrawal penalty tax if the withdrawal occurs before age 59 ½.

In Mary’s case, her tax preparer needs to perform a tax evaluation of the $150,000 cost basis immediately taxed as ordinary income compared to the benefit of the NUA. However, once the shares are in the non-qualified account, Mary can start to sell the stock at capital gains rates, which are currently either 0%, 15% or 20% for long-term assets.

Additionally, the realized capital gains from NUA stock do not add toward the income calculation used for the Medicare Surtax of 3.8%.

Thing to Know Number Three: Create two piles of assets from the 401(K)

You should help Mary divide her 401(K) into two piles:

1 – The company stock

2 – Everything else

Thing to Know Number Four: Moving the Stock to a Taxable Account

The IRS has very specific requirements to follow.

First, the distribution of the company stock to Mary needs to be “in-kind.” That means the distribution of the actual company stock out of the plan directly to Mary into a taxable investment account.

Mary cannot sell the stock in the 401(K) and then transfer cash from the plan to a taxable account. If she did, she would have a taxable event at ordinary income.

Thing to Know Number Five: Rollover Everything Else in the Plan

Mary has to meet the definition of a lump sum distribution meaning the entire account balance of her 401(K) is distributed or rolled over within a single year, typically by December 31 of the year of the transfer.

Therefore, distributions of any other funds in the retirement plan would need to occur resulting in a zero balance in the 401(K) within that year.

Remember, if Mary rolls the entire amount of her 401(k), including the company stock, to another retirement plan or IRA, she will no longer be able to take advantage of the NUA strategy.

Generally, you should execute Mary’s rollover of the $250,000 in non-company stock first (the $250,000 in mutual funds in our hypothetical example) and after the rollover, then distribute the company stock in kind to a taxable account. This will result in the zero balance IRS is looking for.

Thing to Know Number Six: Triggering Events

IRS also requires the lump sum distribution to be the result of a triggering event. These triggering events are:

1.    Death

2.    Attainment of age 59 1/2

3.    Separation from service, or

4.    Disability

Each triggering event provides another opportunity to take advantage of NUA. Let us assume for a moment that Mary reaches age 59 ½ which is a triggering event, but while still employed, takes a partial distribution from the plan, the NUA option is not lost forever. Once Mary retires (separation from service) this sparks another triggering event, giving Mary a new start making the NUA option available again.

If Mary retires and does not take the NUA after this triggering event, the NUA option is most likely lost for Mary’s lifetime. However, when Mary dies, which generates a new triggering event, Mary’s heirs can qualify for the NUA benefit.

Thing to Know Number Seven: Downsides of NUA

1 -       NUA stock in a non-retirement brokerage account is not eligible for a step-up in basis at the death of the original owner.

2 -       A large position in one individual stock can entail more risk than a diversified portfolio of equities.

3 –      NUA requires low cost basis stock in order for it to be effective. It is important that your client consult with their tax advisor before utilizing NUA.

Please feel free to share this with your peers.

My best wishes for a prosperous and healthy New Year.