If you have company stock inside your 401(k), you may have heard of Net Unrealized Appreciation (NUA). But, have you heard of Net Unrealized Depreciation (NUD)? At the end of the day, NUD and NUA could save you a lot in taxes. It is a great time to consider NUD since many stocks are down. To understand NUD, you first need to understand NUA.
NUA: The point of NUA is getting company stock out of your 401(k) at a lower tax rate. It works with stocks that are highly appreciated. Normally, any pre-tax money distributed from your 401(k) is taxed at an ordinary income rate, which could be as high as 37%. If you get part of that money treated as a long-term capital gain, the tax is only up to 20%, greatly reducing your taxes.
To get NUA treatment, you must hold company stock from your current employer inside your 401(k) or profit-sharing plan. You must have a qualifying event like separation from service, turning age 59 1/2, disability, or death. The stock must be distributed in-kind to a brokerage account. The other holdings in the 401(k) must be disbursed in the year of the NUA transaction. You can roll over the remainder of the holdings to an IRA to avoid taxation on that portion. At the end of the year, the 401(k) balance must be zero. Typically, the distribution happens after age 59 1/2 to avoid the 10% early withdrawal penalty on the basis.
The strategy will increase your current year’s tax liability as you will have to pay tax on the basis (Basis = the price at which you bought the stock). To avoid selling stock, you must have cash on hand to pay the taxes when you file your tax return the following year. However, the growth, or Net Unrealized Appreciation, won’t be taxed until you sell the company stock from your brokerage account. The good news is, “The net unrealized appreciation will always be taxed at long-term capital gains rates, regardless of the actual holding period of the stock inside the plan.”*
NUA Example: Let’s say your company stock has really grown in value. You purchased 10,000 shares of stock inside the 401(k) at $1. The stock is now worth $100 per share or $1M total value. If you take out the $1M, you will have to pay ordinary income tax rates of up to 37% or $370,000. If you transfer the shares to a brokerage account as an NUA transaction, you will need to pay taxes immediately on the basis of $10,000, or about $3,700. In the year you sell the stock, you will owe long-term capital gains taxes. Your remaining $990,000 would be taxed at 20%, or $198,000. The total tax would be $201,700, saving about $168,300 in taxes!
NUD: However, what happens if your company stock is down significantly from its high? You wouldn’t seek NUA treatment because your basis is higher than the current value. You would just take it out and pay ordinary income tax rates.
Enter Net Unrealized Depreciation. If your company stock has suffered recently, like many stocks, now is a great time to choose to lower your cost basis on your company stock. This seems counterintuitive since outside of a 401(k), you want the highest basis possible as you have already paid taxes on the basis. However, inside of a 401(k), you haven’t paid tax on the basis. If you can lower your basis, then you can potentially lower your future tax burden.
NUD Example: Let’s say your company stock was worth $100, and you forked out $1M to buy 10,000 shares. Now the stock has tanked and is only worth $1 per share. (Ouch!) If you were over 59 1/2 and took out the $10,000, you would pull that out and pay ordinary income taxes. However, if you aren’t over 59 1/2 or retiring soon, you can really benefit. You can log into your 401(k) portal, sell your company stock, and then buy it back the next day. This will reset the basis. Outside of a 401(k), buying back the same stock the next day is not allowed as it is considered a “wash sale.” But inside the 401(k), it is allowed and does not cause a taxable event. Before selling stock, confirm your provider allows you to trade daily and doesn’t lock you out for 15 days or limit stock purchases.
The purpose of NUD is to set up a future NUA. Keep in mind that investing involves risk, and there is no guarantee your company stock will increase in value. Also, note that it can only be stock for the company where you work. You can’t just buy an individual stock, like Qualtrics (XM) or Domo (DOMO), and then do NUD or NUA unless you actually work for Qualtrics or Domo, respectively.
This is a complex financial transaction with caveats and considerations. It is best to consult with a qualified financial advisor and accountant. If done correctly, you could potentially save yourself a ton in taxes, keeping more of your hard-earned money. If this is something you think will work for you, call us today to talk it through.
Listen to a deep dive about all of this on the Power Up Wealth podcast.
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