So you’ve taken our advice and shucked your 401(k) oyster to discover a shiny, valuable pearl sitting within! After closer examination, the pearl seems to check all the Net Unrealized Appreciation (NUA) criteria boxes:
- The “pearl” is the stock of your employer
- The stock is highly appreciated
- The stock can be distributed from your retirement plan “in-kind”
- You can make a qualified lump-sum distribution from your retirement plan
Excited, you scoop up your oyster and run to the cash register ready to pay the bill. The total rings up and your jaw drops – how in the world will you ever be able to afford your newly discovered pearl?
Luckily, there may also be a coupon lurking within your 401(k) plan.
If you participate in a 401(k) plan through work, you are likely familiar with the annual contribution limitsi.
What you might not know is that the IRS actually allows you to save up to $57,000ii into your 401(k) on an annual basis. The catch is that the excess amountiii can only be funded with after-tax dollars. Unlike your deferral, which is funded with pre-tax dollars, after-tax contributions do not reduce your taxable income.
These after-tax contributions end up being valuable because when you decide to retire and roll out the funds, both your principal contributions and earnings can be rolled into a Roth IRA with no penalty or incurred tax.
All that said, there is a second use for your after-tax contributions where they act as a NUA coupon.
Reducing the Bill
Let’s assume you plan to retire in 2021 and are reviewing your 401(k) options. Within the plan, you:
If you decide to utilize the Net Unrealized Appreciation strategy, all 50 shares of your employer stock will be distributed in-kind to a taxable account. The cost basis of your stock ($150,000) will be taxed as ordinary income meaning a total tax bill of almost $50,000iv!
Here’s where your coupon comes into play as your after-tax contributions can be “applied” towards the cost basis of your stock. For every after-tax dollar you have saved, you can reduce your cost basis dollar-for-dollar. Effectively, you are utilizing your after-tax contributions to reduce your tax bill. In our example above, $150,000 of your after-tax balance can be applied towards the cost basis of Stock A and reduce it down to $0. Your pearl is now free!
The remaining $50,000 of your after-tax balance is not lost – you can choose to roll over that portion into a Roth IRA. You also do not have to apply the full amount of your after-tax balance towards the cost basis. For example, you can choose to apply only $50,000 of your after-tax balance (reducing cost basis to $100,000 and your tax bill to $33,000) and roll over the remaining $150,000 into a Roth IRA.
Entering Your Coupon Code
How much of your coupon should you apply? While it may be tempting to utilize the full amount and walk away with a free pearl, that might not be your best option in the long-term.
In some cases, paying the full tax bill and rolling over your after-tax balance into a Roth IRA can be a more attractive strategy since Roth earnings are tax-free. Ultimately, the answer to the question depends on a number of variables including your 401(k) makeup, investment time horizon, spending needs, current/future tax brackets, and more.
If you’ve discovered a coupon with your 401(k), reach out to your RegentAtlantic Wealth Advisor to help you determine whether you should use it!
i As an employee you can defer up to $19,500 (plus a $6,500 catch-up contribution if age 50+) and your employer can provide a matching contribution
ii In 2021
iii The remainder of $57,000 minus employee deferral minus employer contribution
iv $150,000 * 33% tax rate
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.
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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.