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

Are you an executive who’s watched your 401k company stock drop 30%, 40%, 50% or more? Or maybe it hasn’t dropped yet, but it could.

A sharp decline can feel like a disaster. But here’s the counterintuitive truth: that decline may have just opened the door to a powerful tax strategy, one that could dramatically reduce your future tax bill.

Not recognizing this opportunity? That’s 401k Critical Mistake #6: watching your 401k company stock decline sharply without knowing that a sharp decline could trigger a powerful tax opportunity worth hundreds of thousands.

How a Sharp Decline Could Actually Help You

The answer is a three-letter tax strategy called NUA, or Net Unrealized Appreciation.

Here’s why it matters. Say you have $6,000,000 of company stock inside your 401k. You originally paid $3,000,000 to buy that stock. That $3,000,000 is your cost basis.

Many executives roll their 401k to an IRA. If you roll that $6,000,000 to an IRA and withdraw it later, you’ll pay ordinary income tax on the entire amount. At 37%, that’s $2,220,000.

But with the NUA strategy, here’s what could happen:

You could potentially pay ordinary income tax on just your $3,000,000 cost basis, and the much lower capital gains tax on the $3,000,000 in gains.

Tax on the cost basis: $3,000,000 at 37%, that’s $1,110,000. Tax on the gains: $3,000,000 at 20%, that’s $600,000. Total: $1,710,000.

The potential savings compared to rolling to an IRA and withdrawing it all? $510,000.

Here’s when you’ll pay each tax under the NUA strategy: ordinary income tax on your cost basis when you distribute the company stock from your 401k, and capital gains tax on the gains when you choose to sell the stock in your taxable brokerage account.

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

When a Cost Basis Reset Creates Opportunity and When It Can Backfire

So when could this reset strategy work, and when might it backfire?

Meet Lisa, age 60, an executive whose company stock just dropped sharply. Her tax situation: 37% ordinary income rate, 20% long-term capital gains rate.

When a Cost Basis Reset Creates Opportunity

Lisa originally paid $3,000,000 for the company stock in her 401k. That’s her cost basis. The stock grew to $6,000,000, then dropped 70% to $1,800,000, well below her $3,000,000 cost basis.

If Lisa sells at $1,800,000 and immediately buys it back at $1,800,000, her cost basis drops from $3,000,000 to $1,800,000. That $1,200,000 reduction in cost basis could become critical.

Why? Because the lower her cost basis, the more future growth could be taxed at long-term capital gains rates rather than the usually higher ordinary income tax rates. If the stock recovers and grows, that difference could save her $204,000 in additional savings when the stock is eventually sold, just from the reset.

When a Cost Basis Reset Can Backfire

Suppose instead, Lisa originally paid $500,000 for her 401k company stock. That’s her cost basis. The stock grew to $6,000,000, then dropped 50% to $3,000,000. But she’s still sitting on a $2,500,000 gain.

If Lisa sells her company stock for $3,000,000 and buys it back at $3,000,000, her cost basis jumps from $500,000 to $3,000,000. That’s the opposite of what she wants. In this scenario, selling and buying back after a decline makes things worse, not better. $425,000 in additional taxes when the stock is eventually sold, just from this mistake.

How Do You Know If the Reset Helps or Hurts?

It comes down to one question: is your stock currently sitting at a gain or a loss?

If your stock is below what you originally paid, selling and repurchasing could lower your cost basis. That helps, as more gains could be taxed at capital gains tax rates instead of ordinary income tax rates.

If your stock drops but is still above what you originally paid, selling and repurchasing could raise your cost basis. That hurts.

The good news? Because 401k transactions aren’t taxable events, wash sale rules generally don’t create issues inside your 401k. You can sell at a loss and immediately buy it back, and your cost basis resets for NUA purposes. Most investors can’t do this. But inside a 401k? Generally, you can.

A General Overview of the NUA Strategy

Here’s the key: this cost basis reset only creates value when combined with 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 Right Now

First, determine your gain or loss. Is your 401k company stock below what you originally paid? If yes, a reset could help. If it’s still above what you originally paid, a reset could hurt you.

Second, if the reset makes sense, work with a qualified advisor who truly understands NUA. They can run the analysis, evaluate if this could lower your future tax bill, and execute it with the precision NUA requires.

And third, what if your 401k company stock hasn’t declined yet? Learn this now! Sharp declines happen fast. You need to know what to do the moment it occurs.

Closing Perspective

Here’s the counterintuitive truth: a sharp decline in your 401k company stock? Bad for your balance. Potentially great for your taxes.

If you know how to reset your cost basis and combine it with the right NUA strategy, what looks like a loss can become an opportunity. But this window doesn’t stay open. If your stock recovers, this tax opportunity closes.

In over 30 years, I’ve rarely seen executives use this strategy. Don’t let this window close on you.

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.