You’ve worked hard. You’ve contributed to society. You’ve made sacrifices so you could try to get ahead and realize the American dream. You’ve saved up for your retirement, and now you are ready to take that leap!

As you work through the labyrinth decisions that move you from working and planning and working some more, to drawing an income and conserving value, it is always a welcome discovery to reduce your tax bill and, therefore, add another layer of security to your personal financial outlook.

One of the lesser-known strategies some retirees should consider applies if they have company stock within their 401(k) or Profit Sharing Plan; the special tax election is known by the label Net Unrealized Appreciation (NUA).

Without an NUA Election

As you are likely aware, any pre-tax contributions by you or your employer reduce your taxable income at the time of contribution, and then taxes on the contribution and gains are deferred until distributed. In the year of distribution, you owe ordinary tax rates on the amount distributed. This is true of all money sources except the Roth/after-tax contributions, regardless of how the money was invested.

With an NUA Election

With that baseline understanding, we can comprehend the difference that an NUA election can make. Again, this election may only be applied to shares of company stock held in a corporate retirement plan. If elected, the taxpayer is choosing to pay a front-end tax at ordinary tax rates in exchange for reductions in future taxes, or in some cases, potential elimination of future taxes.

Specifically,

• You pay ordinary tax rates on the basis of the stock in the plan. The basis refers to the initial value of any contributions you or your employer made that were invested in the stock.
• Then, the stock is moved out of tax-deferred status, and any gains over and above that original basis get more favorable treatment as capital gains, a tax that is only owed upon any future sales of shares.

NUA Election Use Cases

The NUA election will not always result in a major financial gain, but it will in many cases. Accordingly, there is no blanket recommendation that you definitely should make this election based on having company stock in your 401(k) or Profit Sharing Plan. Things to look for in deciding whether or not to elect NUA treatment of the stock include:

• If your basis in the stock is substantially lower than the value to which it has now grown, the strategy could be significantly advantageous.
• To put an exclamation point on the advantages of the NUA election, if you think there is a chance you will not need to spend that money in your retirement, it may be possible to leave the shares to your heirs, who may enjoy the step-up in basis, thus eliminating taxes on all gains you earned in the stock within your lifetime (while working and in retirement).

To Elect, Or Not to Elect: That Is the Question

How does one go about deciding if their situation warrants the NUA election? As is the case with any complex tax decision, it really takes a team to weigh the advantages against the risks of the strategy. Your financial strategist should be equipped to help you organize factors relevant to the decision specific to your case. Factors may include quantitative numbers or assumptions, such as:

• The basis of the stock vs. the current value
• Your current top tax bracket with or without this election
• Expectations regarding the direction of future tax rates
• Return expectations and range of return expectations
• Retirement budgeting and spending expectations
• Life expectancy assumptions

Also important to consider are qualitative factors, such as:

• Your goals for those assets (spend vs. leave to heirs or charities)
• Your personal risk tolerance
• The relative strength of your financial plan projection
• Other personal values that could impact your desired strategy

What makes the strategy more attractive is if you have large potential tax savings with minimal downside risk of the election. If there is little benefit expected and substantial risks involved, you’d likely decide against. You can work together with your financial strategist to model different assumptions or contingencies and move toward a path that makes sense. In every case, it is advisable to have a qualified tax professional review your situation and bless your plan of action prior to making your final decision.

Detailed Requirements When Elected

Note that, when implementing an NUA election, you’ll need to carefully clarify that you qualify to make the election; and if so, that you execute the strategy considering any and all limitations and requirements. The intent here is only to raise awareness of the opportunity for consideration. You’ll want to work with your professional team to evaluate and execute any complex strategy such as the NUA election.

Knowledge Empowers

Your McKinley Carter team is well-equipped to see opportunities you may not have been aware existed. In cases like these, we can bring a kind of “energy, enterprise, and thrift” that may create opportunities to reduce your taxes — a rewarding endeavor, for sure.