You’ve been very careful with your 401k plan. You thought you did everything right. But ask yourself three questions:
If your answer to all three questions is YES, there’s a strong chance you’ll make 401k Critical Mistake #5 in THE 10 CRITICAL 401k MISTAKES series.
How so? Read on!
401k Critical Mistake #5 is withdrawing funds from your 401k before you have evaluated if the highly appreciated employer stock in your 401k is eligible for special tax treatment that could potentially save you a lot of money in taxes.
Why is this a mistake? What do you risk losing if you make this mistake?
If you are a candidate for the special tax treatment, and you withdraw funds from your 401k, you might forfeit the ability to receive this special tax treatment that could allow a portion of your 401k employer stock to be taxed at a much lower rate.
To preserve the ability to receive this special tax treatment, specific steps must be followed before withdrawing funds from your 401k.
The case study below shows the impact of withdrawing funds from your 401k before these specific steps are taken.
If you are at least age 59 ½, withdrawals from your 401k will be taxed at the higher “ordinary income” tax rate of 37% on $1,000,000, or $370,000. That’s a lot of tax.
Is it possible for a portion of the employer stock in your 401k to be taxed someday at the lower 20% long-term capital gains rate rather than the higher 37% ordinary income tax rate?
Yes, it is! The strategy to accomplish this feat is a little-known provision in the tax code called “Net Unrealized Appreciation (NUA)”.
It works like this.
Assume you purchase $100,000 of employer stock in your 401k. This $100,000 is called your “cost basis”. Assume your $100,000 of employer stock grows in value to $1,000,000, meaning a gain of $900,000. Inside a 401k, this gain is called “Net Unrealized Appreciation”. Net Unrealized Appreciation is a tax break that allows a portion of your 401k employer stock to be taxed at the lower long-term capital gains tax rate rather than the higher ordinary income tax rate.
Implement the NUA strategy by following these steps:
After your outside taxable brokerage account receives the employer stock from your 401k:
One requirement to qualify for special tax treatment under the NUA strategy is that the transactions you make must qualify as a “lump sum distribution”.
Proceed carefully, as the IRS rules to qualify for lump sum distribution treatment are complex.
One such rule is that after a “triggering” event has occurred, you must distribute the entire vested balance of your 401k during a single calendar year. Therefore, withdrawing funds from your 401k in one calendar year may disqualify you from implementing the NUA strategy in another calendar year.
For example, say you retire and withdraw some funds from your 401k during the year of retirement. Next year, you learn about the NUA strategy and wish to receive the special tax treatment on the highly appreciated employer stock in your 401k. In this scenario, you would not be eligible for the NUA strategy because you didn’t distribute the entire vested balance in a single calendar year.
If you are a candidate for Net Unrealized Appreciation, and you withdraw funds from your 401k, the opportunity for the special tax treatment can be lost.
Important Disclosure InformationApril 2023
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