Roth conversions have, for good reason, become popular among people who want to avoid paying income taxes on the money they withdraw from their IRAs and 401(k)s in retirement.
But there’s another tax-saving option to consider for those whose 401(k) accounts are invested at least partially in their employer’s company stock.
When Roth Conversions Are the Right Move – and When They Aren’t
This option involves something called net unrealized appreciation, or NUA, and those who qualify would do well to explore whether this might be a better alternative for them than a Roth. The key point being, of course, whether you qualify.
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With my clients I find that those in certain professions, such as engineers and people who work in IT, are often more likely to have company stock in their 401(k)s, though others may as well. For them, the NUA can have terrific advantages and, in some cases, drive their tax liability down to nearly zero.
Let’s take a look at how.
How NUA Can Cut Your Tax Bill
First, for the sake of comparison, consider a typical 401(k) of $500,000 that has no company stock. When you begin to withdraw money from that account, you pay income tax based on ordinary tax rates, as if it were part of a salary. For a married couple, that rate is at least 22% for taxable incomes over about $81,000.
But now let's say that your 401(k) includes your company’s stock, and that $100,000 of the $500,000 value of your 401(k) is in that stock. That’s a situation where the beauty of the NUA kicks in.
How to Possibly Pay 0% in Taxes on Your Taxable Investment Gains
Here’s why: You pay ordinary income tax only on the cost basis of the stock; that is, the original amount you invested. So, let’s say you originally paid $10,000 for that stock, which has now grown to $100,000. If you withdraw the $100,000 of stock and sell it, you pay the ordinary tax rate only on $10,000. For the remaining $90,000, you instead pay long-term capital gains taxes. Now this long-term capital gain is only taxable if you sell your company stock.
“OK,” you may think. “That’s still going to be a hefty tax bill.”
Not really, because in 2021 a married couple filing jointly pays no taxes on the first $80,800 of their total taxable income. That’s right. Zero. And from $80,801 to $501,600, the long-term capital gains rate is just 15%. So, let’s break this down for this scenario of $100,000. The couple might pay 22%, or $2,200, for the first $10,000, the basis. They would pay zero for the next $80,800. And they would pay 15%, or $1,380, for the final $9,200. That’s a total of $3,580, compared with possibly $22,000 or more if they didn’t qualify for the NUA.
Alternatively, you can choose to hold your company stock after the NUA in your own individual account and choose when you want to pay capital gains taxes (if any) on the sale.
Some Caveats to Keep in Mind
Are there caveats or additional factors to be aware of with all this? Yes.
- One rule with NUAs is that you can’t own more than 5% of the company. For the average person, that should not come into play, but it’s worth being aware of if you happen to be a major stockholder.
- In the tax year that you do the NUA, you would have to roll tax-free the remaining portion of the 401(k) into an IRA.
- In your retirement years, anytime you withdraw money from an account, you need to be mindful of the potential impact on your Medicare IRMAA, which stands for Income Related Monthly Adjustment Amount. When your income exceeds a certain amount, IRMAA comes into play and can increase the premiums you pay for Medicare Parts B and Part D. So, once you are 65 and are on Medicare, you want to watch carefully the amounts you withdraw from your 401(k) or your IRAs to see how that’s going to affect your IRMMA. Remember, too, that at least part of your Social Security is taxable, so that adds to the overall total.
- Some stocks pay dividends, and in that case, you might want to hang onto the stock after the NUA rather than sell it. The dividends would be taxed at qualified dividend rates, which is 0%, 15% or 20%, depending on your taxable income or filing status. But once again, this would be lower than your tax rate for ordinary income.
You should also compare and contrast the NUA and a Roth conversion to determine which is going to be the better move for you. The answer will depend on a variety of factors, such as what your basis is for the company stock you own. For example, in some cases you might want to use the NUA for only shares with the lowest cost basis and roll over the rest.
A financial professional with experience working with NUAs can help you navigate the pros and cons of the NUA and the Roth conversion, and assist you in figuring out what the most efficient and cost-effective option is for you.
Ronnie Blair contributed to this article.
Disclaimer
Center for Asset Management, LLC (“CFAM”) is an SEC Registered Investment Adviser located in Palm Beach Gardens, Florida. SEC registration does not imply a certain level of skill or training. CFAM may only transact business in those states in which it maintains a notice filing or qualifies for an exemption or exclusion from registration requirements. www.cf-am.com
5 Strategies for Tax Planning Now and in Retirement
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The appearances in Kiplinger were obtained through a PR program. The columnist received assistance from a public relations firm in preparing this piece for submission to Kiplinger.com. Kiplinger was not compensated in any way.
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This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.
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FAQs
Internal Revenue Code (IRC) Section 402(e)(4), Net Unrealized Appreciation (NUA), provides a valuable tax benefit on distributions of your company stock from your 401(k). Specifically, you can avoid income taxes of up to 37% at the federal level on the gains on your company stock upon distribution.
What are the benefits of owning company stock in 401k? ›
"With NUA, when you have company stock in your qualified retirement plan, such as your 401(k), and take a lump-sum distribution from a qualified retirement plan, you can effectively pay lower capital gains rates on a portion of your tax-deferred assets instead of paying the typically higher ordinary income rates when ...
What are the tax advantages of investing in a 401 K? ›
Tax advantages
Because the contributions are pre-tax, it lowers your total taxable income which means you might owe less in income taxes, regardless of whether you itemize or take the standard deduction. It may even put you in a lower tax bracket!
How is company stock in a 401k taxed? ›
The NUA is not subject to ordinary income tax until the company stock is sold and will never be subject to an early withdrawal penalty. When the stock is sold, the NUA is subject to tax at capital gains rates — not ordinary income tax rates, which can be much higher, depending on your income and current tax rates.
How much company stock should I have in my 401k? ›
Some experts recommend investing no more than 10 percent of total investment assets in a single stock, including stock of your company—and that could be too high, depending on your goals and circ*mstances. It's also wise to review your asset mix at least once a year, rebalancing if needed.
Should I have company stock in my 401k? ›
Indeed, a large holding in employer stock doubles your risk: If your company runs into major problems, you may lose your job and your retirement security. Of course, company employees can invest in their employer's stock—through stock purchase plans or stock options at the executive level.
What is the benefit to owning stock in a company? ›
Owning stocks in different companies can help you build your savings, protect your money from inflation and taxes, and maximize income from your investments.
What is an example of a 401k tax? ›
As an example, if you earn $1,500 per paycheck before taxes and you contribute $300 of that money to your 401(k), then you will only be taxed on $1,200. You should note that there are limits to how much you can contribute to your 401(k) each year. For 2024, the limit is $23,000, and $30,500 for those 50 and older.
Which 401k is better for taxes? ›
It can be a surprisingly complicated choice, but many experts prefer the Roth 401(k) because you'll never pay taxes on qualified withdrawals. Contributions are made with pre-tax income, meaning you won't be taxed on that income in the current year.
Is a 401k a tax write off for business? ›
Finally, the IRS has created a small business tax credit to incentivize business to start 401(k) plans. Currently, employers with 100 or fewer employees can write off up to 50% of startup costs of a new 401(k) plan, up to $500 per year for the first three years of a plan.
Even if the value of your stocks goes up, you won't pay taxes until you sell the stock. Once you sell a stock that's gone up in value and you make a profit, you'll have to pay the capital gains tax. Note that you will, however, pay taxes on dividends whenever you receive them.
Can I sell my 401k stocks? ›
This sale and purchase is allowed within a 401(k) without tax implications as long as 401(k) funds are not withdrawn from the account. Be mindful that this sell-and-buy strategy does not apply to non-tax-sheltered accounts that will incur capital gains and/or losses.
What can you do with company stock? ›
For example, the proceeds you generate from selling shares of company stock might be used to maximize contributions to your employer-sponsored retirement plan, pay down debt, make a college tuition payment, or simply diversify your investment holdings.
Can I own stock in a company I work for? ›
Insiders can (and do) buy and sell stock in their own company legally all of the time; their trading is restricted and deemed illegal only at certain times and under certain conditions.
How much should I have in my company stock? ›
Concentrated positions of company stock can carry more market risk than a diversified portfolio, coupled with career risk tied to the company. Holding more than 5% to 10% of your portfolio in company stock is a level of concentration that merits attention. Trimming a position of company stock requires careful planning.
Can I buy my own company stock? ›
Whether or not you're invested in your company's stock via an employer plan, you're free at any time to make purchases on the open market — at least, if you work for a publicly traded company. If so, you can buy or sell as many shares as you want any time the market is open, just like any other investor could.
How much does 401k save you on taxes? ›
How Much Does Contributing to a 401(k) Reduce Taxes? Your 401(k) contributions will lower your taxable income. Your tax owed will be reduced by the contributed amount multiplied by your marginal tax rate. 1 If your marginal tax rate is 24% and you contributed $10,000 to your 401(k), you avoided paying $2,400 in taxes.
Do you get tax breaks for 401k? ›
While 401(k) contributions are not technically tax deductible, these retirement accounts offer significant tax benefits. Contributing pretax into a traditional 401(k) lets you lower your taxable income and defer taxes on your retirement savings until you withdraw it. At that time, you'll pay income taxes on the money.
Does 401k reduce tax return? ›
So how do 401(k)s provide tax advantages to you? As an employee participating in any tax-deferred 401(k) plan, your retirement contributions are deducted from each paycheck before taxes are taken out. Since 401(k)s are taken out on a pre-tax basis, it lowers your taxable income, resulting in fewer taxes paid overall.
At what age is 401k withdrawal tax free? ›
401(k) withdrawals after age 59½
Once you reach 59½, you can take distributions from your 401(k) plan without being subject to the 10% penalty. However, that doesn't mean there are no consequences. All withdrawals from your 401(k), even those taken after age 59½, are subject to ordinary income taxes.
