Company Stock in a 401(k): Net Unrealized Appreciation

Net Unrealized Appreciation (NUA) is the name of a little-known tax break that can help save you money on taxes from employer stock held in a 401(k) plan if you qualify. NUA rules allow you to take employer stock out of your 401(k) upon certain triggering events, only pay ordinary income taxes on the cost basis of the stock (the price you originally paid for the stock) for the withdrawal, and then have the gains taxed at capital gains tax rates. This can be particularly valuable if: 

• You have highly appreciated employer stock (stock with very low-cost basis);  
• You have an immediate need to withdraw money from your 401(k);  
• You are retiring after age 70.5 and you have to take your first required minimum distribution (RMD); or  
• You have a short RMD period, including stretch RMDs. 

The rules for an NUA distribution are very strict, and you should work with your CPA to make sure you follow all the rules precisely. The rules are as follows: 

• You have to distribute the entire balance of your 401(k) and any other qualified plans you have with the employer in a single tax year (some can be withdrawn directly to a taxable account and some can be rolled into an IRA, but there can be no money left in your 401(k) account at the end of the tax year).  
• You must take the distribution of company stock from your 401(k) in actual shares—you cannot sell the shares in the 401(k) and then distribute cash.  
• You must have experienced one of the following triggering events: 
• Separation from service from the company whose plan holds the stock (this may include certain cash buyouts of the company you work for);  
• Reached age 59.5; 
• Become disabled; or 
• Death 

USING EMPLOYER STOCK IN QUALIFIED PLANS

For a number of years, the Internal Revenue Code has included special provisions for qualified plans that invest primarily in employer securities. Congress wants to encourage these plans on the premise that it is desirable to give employees some ownership interest in the company for which they work. The most important special benefit is the leveraging technique for ESOPs, described below, that allows the employer to use the ESOP as a means of financing corporate growth. There are also provisions that encourage the use of a stock plan to help create a market for employer stock.

There are two types of qualified plans that invest primarily in employer securities, the traditional stock bonus plan and the employee stock ownership plan (ESOP). In addition, a regular profit-sharing plan may invest in employer stock without limit, and profit-sharing plans are sometimes used, formally or informally, for this purpose. Qualified pension plans may not invest more than 10 percent of their assets in employer stock, so pension plans are not very useful as employer stock plans.

Advantages of Investing in Employer Stock

There are certain employer and employee advantages to any plan that invests in employer stock, including a regular profit-sharing plan, a stock bonus plan, or an ESOP.

• A market can be created for employer stock. This has many planning implications and is discussed in detail below.

• The employer can obtain a deduction for noncash (that is, employer stock) contributions to the plan.

• Employees receive an ownership interest in the company, which may act as a performance incentive.

• As described below, unrealized appreciation of stock is not taxed to the employee at the time of distribution.