By David L. Dunn, CPA/PFS, CFP®, CPWA®

Do you have highly appreciated company stock inside your 401k? If so, are you thinking about taking a withdrawal to bridge the gap before pension or Social Security kicks in?

Here’s the problem: one withdrawal could wipe out a tax opportunity worth hundreds of thousands of dollars.

The moment you take that first withdrawal, you trigger a deadline. A calendar year deadline. Miss that deadline, and a tax strategy that could have saved you hundreds of thousands disappears forever. And by the time many executives find out, it’s too late.

That’s 401k Critical Mistake #5: taking a withdrawal from a 401k that holds highly appreciated company stock without first understanding the clock it starts and the potential damage it could permanently cause.

How the Clock Starts Ticking

The moment you take that withdrawal, you start this clock. You’ll need to distribute your entire 401k balance by December 31st of that same year, or you could permanently lose the ability to capture special tax treatment on your gains.

Meet James, a 60-year-old executive who just retired. His 401k is worth $2,000,000, which includes highly appreciated company stock. His tax situation: 37% ordinary income rate, 20% long-term capital gains rate.

James takes a $100,000 withdrawal from his 401k in March to cover expenses while waiting for his pension and Social Security to begin. It seemed harmless. He needed the money. He’s retired. It’s his account.

But that withdrawal just triggered a requirement he didn’t know about. By December 31st of that year, his window to use a powerful tax strategy for those company shares will close forever.

What James Didn’t Know

There’s still a path that could save him hundreds of thousands in taxes. That path is a tax provision many executives have never heard of called Net Unrealized Appreciation, or NUA.

James originally paid $200,000 to buy company stock in his 401k. That $200,000 is his cost basis. Over the years, that stock grew to $2,000,000, creating $1,800,000 in gains.

If James qualifies for NUA and acts before December 31st of the same year, here’s what’s still possible for James:

He could pay ordinary income tax on just that $200,000 cost basis, and long-term capital gains tax on the $1,800,000 in gains when he sells.

Tax on the cost basis: $200,000 at 37%, that’s $74,000. Tax on the gains: $1,800,000 at 20%, that’s $360,000. Total tax using NUA: $434,000.

Compare that to what many executives do: roll their 401k to an IRA and withdraw it later, paying ordinary income tax on the entire $2,000,000. At 37%, that’s $740,000 in taxes.

The potential NUA savings? $306,000.

These figures are illustrative. Additional federal and state taxes may apply depending on your situation.

Why the Clock Can’t Be Rewound

That $100,000 withdrawal seemed harmless. But it came with a hidden deadline.

Let’s say James doesn’t learn about NUA until the following year. He took that $100,000 withdrawal in March, and by the time he discovers NUA, a new year has begun. Can he still implement the NUA strategy?

No.

NUA requires something called a “lump sum distribution.” One critical rule: after a triggering event like retirement, you must distribute your entire 401k balance within a single calendar year. James retired. He took a partial withdrawal that same year. But he didn’t distribute everything by December 31st.

Now it’s the following year, and he wants to implement NUA. But the IRS says no, because he failed to distribute his entire balance during the same calendar year as his triggering event.

Bottom line: that $100,000 withdrawal in March didn’t just give him cash. It started a clock that required him to act by year-end, and once that year closed, the NUA opportunity closed with it.

A General Overview of the NUA Strategy

The Net Unrealized Appreciation strategy requires specific steps and precise timing. Get one detail wrong, and the IRS could disallow the entire strategy.

Here’s what typically needs to happen:

First, you need to qualify. There has to be what’s called a “triggering event.”

Second, everything in the 401k that’s NOT company stock typically moves to a new IRA through a direct rollover.

Third, the company stock itself gets transferred, in certificate form, to a taxable brokerage account, not your IRA.

Fourth, these transactions must meet the IRS definition of a “lump sum distribution.”

And fifth, everything must be completed so the 401k balance hits zero by December 31st of the same year.

Your specific situation may require different steps. This is where working with a qualified advisor becomes critical.

What to Do Before Taking Any Withdrawal

If you’re thinking about taking a withdrawal from a 401k that holds highly appreciated company stock, here are three things to consider first:

First, verify you have highly appreciated company stock that might qualify for NUA treatment.

Second, talk to a qualified advisor who understands NUA thoroughly. The NUA rules are complex. Find someone who can evaluate whether this strategy fits your situation.

And third, understand the calendar year deadline that comes with any withdrawal from a 401k holding highly appreciated company stock. Once you take that first withdrawal, the clock starts ticking.

Closing Perspective

While the NUA strategy isn’t right for everyone, if you qualify and it fits your situation, it’s one of the most powerful tax moves an executive can make.

The decision to take a withdrawal can feel entirely harmless. For executives with highly appreciated company stock, it may also be one of the most consequential financial decisions they make without ever realizing it.

The question worth asking before that first withdrawal: do you understand the clock it starts?

Take Action

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Disclosures
David Dunn Wealth LLC (DDW) is a member firm of The Fiduciary Alliance, LLC (TFA), a Securities and Exchange Commission-registered investment adviser. See full disclosure at DAVIDDUNN.COM. Information contained herein is for informational purposes only and should not be construed as a solicitation for investment advice or for the purchase or sale of any securities, insurance, or other investment products. DDW does not provide accounting or public accountancy services. While information contained herein is based on sources deemed reliable, accuracy and completeness aren’t guaranteed