If you are approaching retirement and your 401(k) plan contains significant holdings in appreciated employer stock, you may be able to minimize your tax liability related to that stock. This strategy, which takes advantage of the net unrealized appreciation (NUA) rules, is not right for everyone, but it is worth exploring before you start withdrawing funds from your 401(k) plan or rolling them over into an IRA.

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Three Steps to Take Advantage of the net unrealized appreciation (NUA) Rules

NUA is the excess of the market value of employer securities at the time of distribution over the cost or other basis of such securities.

Generally, distributions from 401(k) plans or traditional IRAs are taxable as ordinary income. But under the NUA rules, you can elect to defer paying tax on the appreciation in value of employer stock until the shares are liquidated. At that time, appreciation may be taxable at favorable long-term capital gain rates.

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The rules are complicated, but in general, you would:

1. Take a lump-sum distribution of your entire 401(k) account at a time when you are eligible due to separation from your employer, disability or reaching age 59½. You must receive actual shares of employer stock rather than their cash value.
2. Move some or all of those shares to a taxable brokerage account, paying ordinary income tax on the stock’s cost basis when the stock is distributed to you. Tax on the shares’ net unrealized appreciation is deferred until you sell them.
3. Rollover any other 401(k) assets into an IRA.

If executed carefully, this process can reduce taxes on the sale of employer stock. But for that to work best, the stock should be distributed at a time when you have little or no taxable income — for example, when you have first retired but have not yet begun to receive Social Security benefits, pensions and other income. Ideally, you would want to time the liquidation of your employer stock shares so that it makes the most of the lowest capital gains tax rate.

But before executing this strategy, consider the broader impact of moving funds into a taxable account — and the possible alternatives. For example, you might benefit from options such as leaving the funds in your existing plan or transferring them into a new employer’s plan. Other considerations are fees, expenses, investment options and creditor protections.

Holding a substantial amount of wealth in one company’s stock is also risky. Your ORBA tax or legal advisor can help you determine whether this strategy makes sense given your situation.

For more information, contact Colin O’ Neill at [email protected] or 312.670.7444. Visit ORBA.com to learn more about our Wealth Management Services.