Latest / The High Net Worth Podcast with Fexingo: Wealth Management, Tax Strategy, and Affluent Finance / How Net Unrealized Appreciation Cuts Taxes on Company Stock
Transcript
- Lucas: Luna, what's the single biggest tax mistake you see highly compensated executives make when they leave a job? Luna: Hands down, it's automatically rolling their 401 into an IRA without considering net unrealized appreciation — NUA. That strategy can save tens or even hundreds of thousands. Lucas: Right. NUA is one of those provisions that sounds like a loophole but is actually codified in Section 402 of the Internal Revenue Code. If you hold employer stock in your 401 that has appreciated significantly, you can pull those shares out as a lump-sum distribution and pay tax only on the cost basis — the original value — at ordinary income rates. Everything above that gets taxed as a long-term capital gain when you sell. Luna: So instead of paying 37% on the entire distribution, you potentially pay 20% on the appreciation. That's a huge delta. Lucas: Exactly. Let's put numbers on it. Suppose you're a senior engineer at Microsoft who accumulated $2 million in company stock inside your 401 over 20 years. Your cost basis, what you originally contributed, might be $500,000. The remaining $1.5 million is net unrealized appreciation. Luna: Versus NUA: You take the stock shares in-kind to a taxable brokerage. You pay ordinary income on just the $500,000 cost basis — about $185,000 at 37%. The $1.5 million carries a 20% long-term capital gains rate when you sell, so $300,000. Total tax: $485,000. That's a $255,000 savings. Lucas: And that's before state taxes. In a high-tax state like California, the savings can be even larger because NUA avoids state income tax on the appreciation portion — capital gains rates are generally lower than ordinary income rates at the state level too. Luna: But it's not automatic. There are strict rules. The distribution has to be a lump-sum — meaning all your company stock from that plan must come out in one calendar year. And you need to have experienced a so-called 'separation from service' — usually leaving the company, retiring, or turning 59 and a half. Lucas: Right. And if you've already rolled the stock into an IRA, you can't retroactively apply NUA. The IRS is very clear: the stock must be distributed directly from the qualified plan. So you have to decide at the moment you leave the job. Luna: That creates a decision point. Many people don't even know it's an option because their plan administrator doesn't highlight it. The default advice is 'roll it into an IRA' — which is usually good advice, but not when you have a concentrated winner. Lucas: Exactly. Another nuance: you can actually split the distribution. You can roll some of the other assets — like bond funds or international equity — into an IRA, and only distribute the company stock under NUA. The IRS allows a partial lump-sum for just the employer securities. Luna: That's smart. But there's a risk: you're now holding a huge bet on one stock outside a retirement account. If that stock drops, you can't get the tax benefit back. So you need to have a plan for diversification, maybe using options or simply selling gradually. Lucas: Right. The classic play is to sell the appreciated shares over multiple tax years to manage the capital gains bracket. For most high-income individuals, the 20% rate applies, but there's also the 3.8% net investment income tax above $200,000 for singles, $250,000 for couples. So effective federal rate can be 23.8%. Luna: Still better than 37%. And if you hold the shares until death, your heirs get a step-up in basis, eliminating the capital gains tax entirely. That's another layer of estate planning value. Lucas: Great point. NUA can also interact with the qualified business income deduction if the executive is also a business owner, but let's not go there today. The key takeaway: if you have company stock with a low cost basis in your 401 and you're about to leave your job, NUA is worth a serious look. Luna: One more thing: the stock has to be 'employer securities' as defined by the plan. That means common stock of the company you worked for. Not mutual funds, not ETFs. So this is mainly for employees at publicly traded companies. Lucas: Yes, and some plans require you to take the entire account as a lump sum to qualify for NUA, not just the stock. So you need to check the plan document. But if the numbers work, it's one of the few ways to arbitrage ordinary income and capital gains rates inside a retirement account. Luna: Before we wrap, I want to mention that if this episode helped you think about a distribution decision, that's exactly the kind of value we aim for here. The show stays ad-free thanks to listener support. If you'd like to keep that going, you can find us at buy me a coffee dot com slash fexingo. Lucas: Yeah, it genuinely helps. Now back to NUA: one final caution — timing. The distribution must be a lump-sum within one tax year. If you take an in-service distribution before separation, it doesn't qualify. So if you're still at the company, NUA isn't available. Luna: Right. And if you die while still employed, the beneficiary can still use NUA on a lump-sum distribution, but the rules are complex. Better to plan ahead. Lucas: Bottom line: NUA is a powerful but underused strategy. If you're a high-income professional with company stock in your retirement plan, talk to your advisor before you sign that rollover form. The savings can be life-changing. Luna: Well said. That's all for today. We'll be back with another deep dive on wealth management strategies soon.