Taking an Early 401(K) distribution can be a savvy move with the Net Unrealized Appreciation Tax Rule

Common thinking with regard to 401(k) plans is to roll them over into low cost IRA’s as soon as employment has ended, thus allowing assets to grow with the least bite taken out of them both in terms of fees, because most 401(k) plans offer higher fee mutual fund options rather than lower cost index fund, and in taxes, since if you cashed out the 401(k) you get hit with a penalty of 10% if under 59.5 years old and a hefty tax bill as the money is counted as regular income.

However, there is a special rule that applies specifically to company stock held within the profit sharing plan, and it would be wise to talk with your accountant about this if you have stock that has grown in value.  Certain restrictions do apply, and you must have a lump sum distribution option available.  The rule is called the Net Unrealized Appreciation (NUA) rule, and it allows you to pull company stock out of the plan and into a Taxable account with the following preferential tax treatment:

• When you make the transfer you will pay tax at your ordinary rate on the basis, not the value of the stock (a 10% penalty may be added on if you are under 59.5 years of age at the time of the transaction).
• When you sell the stock you will be subject to tax at capital gains rates on the NUA portion of the asset.

The 10% penalty sounds prohibitive, and clearly it would be better if avoided by being over the age limit for the distribution, but I will go through an example where it is in play and why that makes sense still.

Jane is 40 years old, she has worked for IBM for 18 years and during that time has built up a 401(k) valued at $400,000 of which $240,000 is held in Mutual Funds and $160,000 is held in IBM Stock.  Her company HR informs her that her basis in the stock is $10,000 meaning that the the stock has gained $150,000 in value during the time of her ownership, in other words the NUA portion is $150,000.

Assumptions: Her current effective tax rate is 28%

Option 1 Roll Everything into a Vanguard Traditional IRA to invest in low cost funds

If she rolled everything into an IRA there would be no tax recognition event and she would owe nothing to the IRS, she would simply have an IRA valued at $400,000 which would grow in time and she would then pay tax on in retirement.  That means that the money from the IBM stock ($160,000) would be taxed at her ordinary tax rate (deferred until retirement).

Option 2 Roll the Mutual Funds into the Traditional IRA, and take the IBM stock out

By rolling the mutual fund money ($240,000) into the IRA she would owe no taxes on it, just as in Option 1.  However if she pulled out the IBM stock under the NUA rule she would have the following:

• Tax on basis of IBM stock = $10,000 x 28% for $2,800
• Penalty on early distribution = $10,000 x 10% for $1,000
• Total Federal Tax due at time of distribution = $3,800

At this time, the stock does not have to be sold, it can be moved as stock from the 401(k) into a Taxable Brokerage account, when it is sold in the future it would be taxed at Capital Gains rates, rather than Ordinary Income rates.

The NUA portion of the IBM stock is $150,000 at the long term capital gains tax rate of 15% the tax on the sale would be $22,500.  Your total tax liability to ‘cash out’ the stock would be $26,300 or an effective tax rate of 17.5%, in Jane’s case she has just saved 10.5% in taxes based upon her current ordinary tax rate, which is a savings of $15,750.  By paying a penalty, and not doing the tax savvy thing, she has saved a large amount of money.   It is worth noting that the amount may be subject to the 3.8% Medicare Surcharge tax also, and if so would still be a better proposition than rolling over, with an effective tax rate of 21%.

The NUA rule works best when there is a large amount of appreciation from the Basis, and is something you should chat with a Tax Professional about prior to making any decisions to roll over or not (ideally talk with them before you leave your current employer so you can plan properly) and note that if you are under the age of 59.5 you can still avoid the 10% penalty if your withdrawal is considered exempt from that penalty, which happens under several conditions – you can look them up here on the IRS Website Page

There are a lot of moving parts to this calculation, including your effective tax rate now, and expected tax rate in retirement, but it is something that anyone with appreciated company stock in their 401(k) should be mindful of.