If you happen to inherit a 401(k), generally the best option is the roll the assets over into an Inherited IRA and take distributions over your lifetime. However, before doing so, you might want to take a closer look at the holdings in that 401(k) account.
Numerous company 401(k)’s, including many we run across frequently here in New Jersey (Prudential, Johnson & Johnson, and ADP for example) feature company stock as an investment option with their retirement plans. Often times we find that individuals hold company stock with low basis and high current values, as employees have acquired the stock over their long tenures at these organizations. Upon retirement, we often encourage clients to take advantage of Net Unrealized Appreciation (NUA). The IRS allows a NUA distribution in the following scenarios: after age 59 ½, separation from service, disability (for a self-employed individual), or on the plan participant’s death. This final scenario provides the ability for the beneficiary of a 401(k) to take advantage of NUA.
NUA allows individuals to take an in-kind distribution of stock to a taxable account rather than rolling it directly to an IRA. The individual pays income taxes on the cost basis of the company stock and then pays capital gains tax on the sale of the stock when it is sold. Even if you sell the stock the next day after completing the NUA transaction, the sale qualifies for treatment as a long-term capital gain. Taxpayers in the 10% and 15% income tax brackets pay no tax on capital gains while taxpayers in the 25% to 35% brackets pay 15% capital gains, and those in the top tax bracket pay 20%. In all scenarios, the capital gains rate is much less than the ordinary income tax rate, providing the opportunity for significant tax savings for the 401(k) beneficiary.
In addition, NUA escapes the Medicare Surtax of 3.8%, even if you hold the stock and sell it at a later date, as the IRS considers NUA a distribution from a qualified plan. Any additional gain on the stock between the date of the NUA transaction and the eventual sale would be subject to the surtax. Those who inherit 401(k)’s and roll the assets to an IRA are then required to take a Required Minimum Distribution each year based on their life expectancy. This distribution is taxable at ordinary income rates. Utilizing NUA to remove a portion of the 401(k) assets would lower the RMD required each year, saving the individual on future income taxes.
Despite the potential substantial tax savings, there are a few caveats that individuals should be aware of. For one, there is tax due immediately upon the NUA transaction. If you hold the stock until death, your beneficiaries are then not eligible for a step up in basis as they would receive the same tax treatment upon liquidating the shares as the original owner of the shares. In addition, if the stock makes up a large portion of the 401(k), utilizing NUA eliminates the ability for you to diversify that concentrated holding without major tax consequences.
NUA provides a great opportunity for an investor in a high tax bracket with appreciated company stock in their 401(k) to realize significant tax savings. Consider the following example for a client with $50,000 in company stock, a $10,000 cost basis, 39.6% marginal income tax rate, and a 20% capital gains tax rate. If the individual holds the stock for a 10 year period and we assume a conservative investment return of 5% annually the individual would experience about $13,000 in tax savings.
Important disclosure information
Please remember that different types of investments involve varying degrees of risk, including the loss of money invested. Past performance may not be indicative of future results. Therefore, it should not be assumed that future performance of any specific investment or investment strategy, including the investments or investment strategies recommended or undertaken by RegentAtlantic Capital, LLC (“RegentAtlantic”) will be profitable.
Please remember to contact RegentAtlantic if there are any changes in your personal or financial situation or investment objectives for the purpose of reviewing our previous recommendations and services, or if you wish to impose, add, or modify any reasonable restrictions to our investment management services. A copy of our current written disclosure statement discussing our advisory services and fees is available for your review upon request.
This article is not a substitute for personalized advice from RegentAtlantic. This article is current only as of the date on which it was sent. The statements and opinions expressed are, however, subject to change without notice based on market and other conditions and may differ from opinions expressed in other businesses and activities of RegentAtlantic. Descriptions of RegentAtlantic’s process and strategies are based on general practice and we may make exceptions in specific cases.
RegentAtlantic does not provide legal or tax advice. Please consult with a legal and or tax professional of your choosing prior to implementing any of the strategies discussed in this article.