Why is net unrealized appreciation a useful tool?
The greatest potential benefit of net unrealized appreciation is the ability to apply long-term capital gains rates on appreciation versus paying ordinary income. Long-term realized capital gains are subject to a substantially lower tax rate than ordinary income up to a rate of 20% versus up to 37% for ordinary income. In its simplest form, NUA is the difference in value between the cost basis of the company stock and its market value at the time it is distributed.
Net unrealized appreciation (NUA) only applies to the company stock inside of your 401k plan so only a select group of people can consider NUA as an option.
For example, if you work at Boeing or Chevron, and you have put $30,000 of your own money into company stock, and now the stock is worth $130,000, you have an unrealized gain of $100,000. That in its simplest form is net unrealized appreciation.
If you sold the stock and you rolled it into your IRA, you now have $130,000 of cash in your IRA that when distributed will be ordinary income. Utilizing NUA, when you have a gain, you could potentially pay long-term capital gains tax, which is typically much lower on the $100,000 gain versus paying ordinary income.
Is there a time that net unrealized depreciation might not make sense?
There are a few reasons NUA might not make sense.
For NUA to make sense, you must have a gain. If you call your employer and you see you have $30,000 of company stock X, but you see that your basis in it is $50,000, it has gone down in value so there is no appreciation and therefore no benefit to distributing the money. In addition to that, you must have had a triggering event. A triggering event could include either separating service from the company or turning 59 ½ to take a full distribution of the plan. You would roll the other assets into your IRA, and you would push out the stock into a brokerage account. If you are over 59 ½ or you have separated service from the company that would allow you to take the money out.
The other reason it may not make sense to utilize NUA is if you cannot afford to pay the taxes. The basis that comes out is going to be taxable to you as ordinary income in the year that you take it out. You want to work with your accountant and financial advisor to make sure you are prepared for what the tax bill will be and make sure you have the funds available to pay the tax. Said another way, it does not make sense to use your IRA money to pay the tax bill. You want to make sure you have the cash available from another source to pay the taxes.
Is there anything else you think would be important to know about net and realized depreciation?
The other potential benefit is the growth of that money. If you are age 60 for example, and you pushed out $100,000 of company stock, with the rule of 8%, the money would double in nine years. That means $100,000 would have grown to about $250,000 by the time you are 72. All of that is going to be subject to the required minimum distributions (RMD) if you leave it in your IRA. So, if you have it outside of your IRA, that growth is not subject to the RMD.
Depending upon your risk tolerance, your age, and the percentage of your net worth, with the money you pushed out at $100,000, which is now $250,000, if you held onto it until the end of your life, and it grew to $400,000 at death under current tax law, your heirs would get a full step-up in basis. They would pay no income tax, (they may potentially pay estate tax depending upon the size of your estate), but they would pay no tax on all the growth. So, there is some potential for a big benefit in reducing your RMD and possibly a step-up in basis at death.
The last and the most important thing for a lot of people I run into is creating after-tax assets. A lot of people have giant IRAs (Individual Retirement Account), giant 401ks, and not very much in after-tax money because they have worked for big companies.
They have deferred, they have been matched and it has grown for many years. So, they end up with this big IRA. This is a pretty tax-efficient way potentially for those that it applies to create an after-tax benefit.
Still have questions? We are here to help.
If you would like us to look at your retirement and see if you are utilizing the best possible options, we would love to meet with you and learn more about your goals to see if there is a good fit for us to work together. Reach us at 562-432-3783 or [email protected] to schedule a free introductory meeting.
*This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.