IRA Rollovers: Watch out for Net Unrealized Appreciation!

As clients approach retirement, they often ask what they should do with the assets in their 401(k) plan. Usually, we advise them to roll their plan assets into an Individual Retirement Account (IRA). IRA's generally provide greater flexibility, more investment options and lower overall costs. But there are exceptions. One of the most important exceptions arises if your employer allows you to buy employer stock in your 401(k) plan.

Highly-appreciated employer stock in a 401(k) plan is eligible for special tax treatment called net unrealized appreciation or NUA. Under IRS regulations, taxable distributions of NUA stock are taxed in two steps. The first step occurs at the time of distribution when you pay tax on the cost-basis of the distributed employer stock as if it were ordinary income. The second step occurs when the stock is actually sold. At that time the difference between the sales price and the cost basis is recognized as a long-term capital gain. Without NUA treatment, distributions from a 401(k) plan are all taxed at the higher ordinary income tax rate.

The following example will help clarify the situation:

Tom has worked for X-Tech for the past 15 years. Over the years, he has accumulated a significant amount of X-Tech stock in his 401(k) plan. His cost basis in X-Tech is $150,000; it is currently worth $2 million.

With retirement fast approaching, Tom has to decide what to do with his 401(k) plan. His brother-in-law encourages him to roll it over into an IRA and get it diversified. After all, if something were to happen to X-Tech stock, Tom would lose a significant part of his retirement savings. No taxes will be paid at the time of the rollover, but down the road, when Tom eventually takes any withdrawal, he will have to pay taxes on those withdrawals as if they were ordinary income. At a 35% tax rate, this means Tom will eventually pay $700,000 in taxes on his $2 million worth of X-Tech stock.

Fortunately, before rolling it over, Tom hears about net unrealized appreciation. Based on NUA tax treatment, Tom realizes he would be better of taking his X-Tech stock as a taxable distribution and then selling the stock. In this case he pays $52,500 in ordinary income tax (his cost basis of $150,000 times his marginal tax rate of 35%) plus $277,500 in long term capital gains taxes (his unrealized appreciation of $1.85 million times the long-term capital gains tax rate of 15%.) With NUA, Tom's total tax bill on X-Tech is $330,000--less than half of what it would have been had he rolled it over into an IRA. Of course, Tom could also leave it in the 401(k) plan and defer all taxes until some point in the future.

The net effect of NUA is to significantly reduce the tax burden associated with employer stock in an employer sponsored retirement plan. But it is critical to understand that if the employer stock is rolled into an IRA, that tax advantage is lost. While IRA's are a powerful tool for retirement planning, they have to be used carefully.