There are approximately 232 million more Google searches for cute puppies than there are for net unrealized appreciation (NUA), so please forgive me for the clickbait-y title to this piece – it's only meant to draw attention to a wonderful tax and estate planning strategy that is rarely utilized.
What Is NUA?
NUA is the difference in value between the current market value and the cost basis of company stock held in an employer-sponsored retirement plan, such as a 401(k).
Why Is It Advantageous?
An example is the best way to illustrate. The following is loosely based on a client for whom we help execute the strategy.
John was a long-time employee at a local, publicly traded company. He had just over $1 million accumulated in the company 401(k) plan. Company stock made up around $300 thousand of the balance. The cost basis in that stock was $100 thousand. When John retired, we could have rolled the entire balance of the 401(k) plan into an IRA, but instead we had the stock distributed in-kind to a brokerage account just in his name. The remaining non-stock balance was then rolled into an IRA.
John was taxed on $100 thousand (the cost basis of the stock) as ordinary income. If John sells the stock later, he will be taxed on the NUA (difference between current market value and $100 thousand) at a long-term capital gains rate, as opposed to the ordinary income tax rate to which the IRA distribution will be subjected.
Why Did We Do This?
John had retired in his mid-60s and had enough income through a pension and social security. He was never going to need to use this money. If he rolled the stock into his IRA, the stock would have been subject to required minimum distributions that would be taxed at ordinary income tax rates. If he passes away, his beneficiaries would pay ordinary income tax rates on the distributions from the inherited IRA.
By making the NUA election, the stock can appreciate and his beneficiaries will receive a step-up in basis at John’s death, which means that none of that appreciation will ever be taxed (to John or his beneficiaries).
Sounds Complicated … Is It Worth It?
It is complicated and needs to be executed flawlessly. Make sure to consult with your financial planner, tax advisor, plan administrator, etc., before attempting. It doesn’t always make financial sense, but when it does, it can be very lucrative. In John’s case the stock is now worth $600 thousand. If he dies tomorrow and his beneficiaries redeem the stock right away, there are no taxes due. If the NUA strategy hadn’t been utilized, then ordinary income tax would be owed on $600 thousand whenever the beneficiaries withdraw the funds.