A little known tax break could save you money during an IRA rollover

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Businessmen working on computersThere is a little known provision in the Internal Revenue Code that can provide a huge income tax advantage for certain taxpayers in the right circumstances. Although conventional wisdom tells us to roll over our retirement account assets to a rollover IRA account when we leave an employer or retire, the availability of the Net Unrealized Appreciation (NUA) tax strategy requires very careful consideration before we roll over these assets. 
If you own highly appreciated employer stock in your company’s 401(k) or other retirement plan, you may be quite a bit better off withdrawing the employer stock personally and rolling over only the other plan assets into a rollover IRA. If you follow the letter of the law, you will pay no current income tax on the employer stock’s prior appreciation or on the other assets rolled over to the rollover IRA. The only income tax you pay in the year of distribution would be on the cost basis of the employer stock held inside the retirement account. 
The greater the amount of appreciation in the employer stock held in your retirement account, the more advantageous this tax break becomes. The mechanics of this strategy are somewhat complicated but an example should help clarify how this works. Let’s assume you are nearing retirement and have a 401(k) with your employer valued at $1 million. Let’s further assume that the largest asset in your 401(k) is employer stock valued at $750K with a cost basis of $100K. Therefore, the employer stock has appreciated $650K (this is the NUA).
You direct your employer to distribute the $750K in employer stock, in kind, directly to you and you roll the other $250K in plan assets to a rollover IRA. You sell the employer stock the next day for $750K and you pay long-term capital gain on the $650K in appreciation you built up over the years. Under our current capital gain tax rate structure, this $650K would be taxed at 20%. Importantly, the IRS has made clear that the sale of NUA stock is exempt from the 3.8% net investment income tax that is generally added when we recognize a large capital gain event. As noted previously, you will also pay ordinary income tax on the $100K of cost basis in the employer stock that was distributed to you.                                            
If instead, you rolled the entire $1 million in plan assets into a rollover IRA, the NUA tax break is forever lost. An IRA rollover permanently kills any possibility of getting NUA tax treatment for the employer stock and is irrevocable. Once rolled over, any future distributions out of your rollover IRA will be taxed at your prevailing ordinary income tax rate which could be as high as 39.6%, depending on your particular situation.
To qualify for the NUA tax break, you must take a distribution of 100% of the retirement account during the year (the retirement account balance must be zero by the end of that tax year). The 100% distribution must also occur after any one of these four triggering events:
1) Death
2) Reaching age 59½ 
3) Separation from service
4) Disability
The favorable NUA tax treatment also applies when employer stock is distributed to the employee’s beneficiaries after the participant’s death. 
For most retiring employees, rolling over a lump sum distribution received from their employer plan is generally the best tax deferral and financial planning strategy. The opportunity for continued tax-deferred growth of retirement assets inside an IRA is extremely valuable for most retirees. That said, the possibility of NUA tax treatment for certain retirees holding highly appreciated employer stock should force us all to slow down and analyze our particular situation before we make an irreversible rollover decision.
If you are holding highly appreciated employer stock in your employer-sponsored retirement account, we would love the opportunity to discuss the NUA strategy with you.     
SKR+CO Expert
Bernie Benyak, CPA, CFP®, NSSA® Tax Director
Bernie has been in public accounting since 1995. His specialties include working with small business owners, relatively high net worth individuals, and real estate companies.