The tax break provided for net unrealized appreciation (NUA) on 401(k) account distributions once provided a powerful tax savings strategy for clients with large 401(k) balances—allowing some clients to reduce their taxes on these retirement funds by as much as 20%. Today, as high-net-worth clients are increasingly seeking strategies to help minimize their tax burdens in light of higher 2013 tax rates, the NUA strategy may have become more complicated than ever.
Therefore, it's important for advisors to help clients evaluate whether or not the NUA strategy still works, because for some clients, what was once a significant tax-savings strategy might be gone in 2013—especially for those who are newly subject to the 3.8% investment income tax.
NUA Strategy: The Basics
The NUA strategy allows certain taxpayers whose 401(k) plans contain appreciated securities of their employers to pay taxes on the appreciated value of those securities at the capital gains tax rate. The remaining 401(k) funds are taxed at the taxpayer's ordinary income tax rate under the traditional rule for taxation of 401(k) plan distributions.
In order for a client to take advantage of the NUA strategy, he or she must be eligible to take a lump sum distribution from the 401(k) account in question—meaning that the taxpayer must have reached age 59½, become disabled or retired (for certain employees) or died. The eligible client transfers the funds in his or her tax-deferred account into a taxable account, realizing the gain on the sale of the employer securities.
This strategy has proven effective for some clients—for example, if employer securities within a client's 401(k) are worth $100,000, but originally cost $20,000, only that $20,000 would be taxed at the client's ordinary income tax rate. The remaining $80,000 would be taxed at the applicable long-term capital gains rate.
NUA Considerations Today
Today, the ordinary income tax rate for high income clients has increased from 35% to 39.6%—but the top long-term capital gains rate has also increased, from 15% to 20%. Taken alone, these rate hikes would seem to preserve the benefits of the NUA strategy—but the additional 3.8% tax on net investment income requires closer consideration.
While retirement account distributions are generally exempt from the 3.8% investment income tax, the NUA strategy means that the appreciated value of the employer securities held within a client's retirement account will be treated as capital assets. This means that the 3.8% tax may be added to the otherwise applicable capital gains tax.
