High stock values and layoffs combine for big tax breaks on company stock

With the net unrealized appreciation tax break, company stock can be withdrawn from a 401(k) in a lump-sum distribution and have its appreciation taxed at capital gains rates, rather than as ordinary income.

As stock values continue to rise to record levels, unfortunately so do layoffs.

In 2023, more than 260,000 tech employees were let go, according to layoffs.fyi, a site that tracks job cuts. That includes workers at Google, Amazon, and Microsoft, some of the world’s most valuable companies.

Citi recently announced plans to eliminate 20,000 jobs, or roughly 10 percent of its workforce. Macy’s is cutting more than 2,000 jobs. UPS just announced 12,000 layoffs, and even the venerable Sports Illustrated has just wiped out most of its company employees – does that mean no swimsuit issue this year?

Layoffs mean rollover opportunities. Advisors will need to get up to speed on how to guide these employees on their plan distribution options. A good chunk of these people are likely to have large 401(k) balances representing a significant portion of their net worth.

In addition, there are new Department of Labor fiduciary rules that focus on advice given on rolling assets over to individual retirement accounts. Advisors will need to know which options are best for their clients, and the stakes are high because some of these choices are irrevocable.

Company stock opportunities

Increased stock values mean more appreciation on company stock held in 401(k) plans. This presents an opportunity for laid-off employees to consider taking a lump-sum distribution to capitalize on the net unrealized appreciation, or NUA, tax break on company stock held in their 401(k)s.

The NUA tax break allows company stock to be withdrawn from the plan as part of a qualifying lump-sum distribution and have its appreciation at distribution taxed at long-term capital gains rates when the stock is sold, rather than as ordinary income – even if the stock hasn’t been held for more than one year. (Any appreciation from distribution date to date of sale is taxed as ordinary income if not held for at least one year.)

If the funds were simply rolled over to an IRA, the NUA tax break would be irrevocably lost, and eventual distributions from the IRA would be taxed at ordinary income tax rates. This is why it’s so important for advisors to identify NUA candidates and evaluate that option before opting for the more common IRA rollover.

WHO QUALIFIES FOR NUA TAX BREAK?

Ask these two questions:

1. Do you have company stock in your 401(k)?

2. Has the stock’s value appreciated a great deal from the original cost of the shares when they were purchased in the plan?

If the answer to the two questions is “yes,” the employee is a good candidate for the NUA tax break.

HOW DO THEY QUALIFY?

First, there must be a triggering event, like a layoff, retirement, or other separation from service. (Other triggering events include reaching age 59½; disability, but only for the self-employed; or death. So even some employees who weren’t let go might qualify under these events.)

Second, the distribution must be part of a qualifying lump-sum distribution, where all the plan assets are distributed in one calendar year after the job loss or other triggering event. It does not have to be the same calendar year as the triggering event. It can be any calendar year after that, as long as all the plan funds are distributed in that year.

EXAMPLE OF HOW NUA WORKS

John, age 62, is a tech employee who has just been let go from XYZ Tech Corp. in the recent wave of layoffs. His 401(k) balance is $1 million, but $800,000 of that balance is held in XYZ company stock. The original cost of those shares over the years was only $100,000, but the stock gains over the last decade have resulted in significant appreciation. John is a prime candidate for taking a lump-sum distribution and using the NUA tax break. The NUA here is $700,000, which is the difference between the $800,000 market value today and the $100,000 basis in the plan.

Since the tax break applies only to the XYZ company stock, John can first roll over the $200,000 non-company assets in the plan to an IRA as a tax-free rollover. That will leave only the $800,000 of company stock. That $800,000 (of which $700,000 is NUA) can be distributed to a regular brokerage account (not to an IRA). Upon distribution, John will pay ordinary income tax on only the $100,000 cost. (If John were under age 55, he could also be subject to a 10 percent early withdrawal penalty, but only on the $100,000 cost.)

The stock in the brokerage account can be withdrawn at any time. In fact, if it’s never withdrawn during John’s lifetime, his beneficiary may also qualify for the NUA break. (Although NUA never receives a step-up in basis, there would be a step-up on any lifetime appreciation after the date of the distribution from the plan.) Whenever the NUA stock is sold, it will qualify for the favorable long-term capital gain rates. That can be a big tax break, given the high appreciation in this example.

This is a simplified example showing the mechanics of the NUA tax break. In this example, all the NUA stock was withdrawn, but clients can choose to withdraw part or none at all and roll the stock to an IRA (but then the tax break is lost). However, the more dollars that are dedicated to the NUA break, the fewer plan funds will be going to the IRA, thereby lowering future required minimum distributions.

Advisors will first want to see how much appreciation there is before advising on the lump-sum distribution. Obviously, this tax break is best when appreciation is the highest, but given today’s stock values, that may be right now.

Now, early in the year, is the time to start planning the NUA transaction, since it can take time to implement.

Layoffs can be crushing, so why not show clients this silver lining? The idea of turning a job loss into a big tax break may help soften the blow.

For more information on Ed Slott and Ed Slott’s 2-Day IRA Workshop, please visit www.IRAhelp.com.