NUA Strategy, Part 2: Put Your After-Tax Contributions to Work
Let’s say that after reading the first part of our mini-series, you’ve taken our advice and shucked your 401(k) oyster to discover a shiny, valuable pearl sitting within! After closer examination, the pearl seems to check all the Net Unrealized Appreciation (NUA) criteria boxes:
- The “pearl” is the stock of your employer
- The stock is highly appreciated
- The stock can be distributed from your retirement plan “in-kind”
- You can make a qualified lump-sum distribution from your retirement plan
Excitedly, you scoop up your oyster and run to the cash register, ready to pay the bill. The total rings up, and your jaw drops—how in the world will you ever be able to afford your newly discovered pearl?
Luckily, there may also be a “coupon” lurking within your 401(k) plan.
If you participate in a 401(k) plan through your workplace, you are likely familiar with the annual contribution limits. In 2023, as an employee, you may defer up to $22,500 (plus a $7,500 catch-up contribution if age 50+), and your employer can provide a matching contribution.1 What you might not know is that the IRS actually allows you to save up to $66,000 in your 401(k) on an annual basis.2 The catch is that the excess amount may only be funded with after-tax dollars.3 Unlike your deferral, which is funded with pre-tax dollars, after-tax contributions do not reduce your taxable income.
We believe these after-tax contributions end up being valuable because, when you decide to retire and roll out the funds, both your principal contributions and earnings can be rolled into a Roth IRA with no penalty or incurred tax.
Having said that, there’s also a potential second use for your after-tax contributions, where they act as an NUA “coupon.”
Reducing the bill—a hypothetical example
Let’s assume you plan to retire sometime in 2023 and are reviewing your 401(k) options. Within the plan, you:
If you decide to utilize the NUA strategy, all 50 shares of your employer stock will be distributed in-kind to a taxable account. The cost basis of your stock ($150,000) will be taxed as ordinary income, meaning a total tax bill of almost $50,000.4
Here’s where your “coupon” comes into play. Your after-tax contributions may be “applied” toward the cost basis of your stock. For every after-tax dollar you have saved, you can reduce your cost basis, dollar for dollar.5 Effectively, you are utilizing your after-tax contributions to reduce your tax bill. In our example above, $150,000 of your after-tax balance can be applied toward the cost basis of Stock A and reduce it down to $0. Your pearl is now tax-free!
The remaining $50,000 of your after-tax balance is not lost—you have the option to roll over the growth portion into a Roth IRA. Another option is to not apply the full amount of your after-tax balance toward the cost basis. For example, you can choose to apply only $50,000 of your after-tax balance (reducing the cost basis to $100,000 and your tax bill to $33,000).
Entering your coupon code
How much of your “coupon” should you apply? While it may be tempting to utilize the full amount and walk away with a free pearl, that might not be your best option over the long term.
In some cases, we believe paying the full tax bill and rolling your after-tax balance into a Roth IRA can be a more attractive strategy since Roth earnings are tax-free. Ultimately, the answer to the question depends on a number of variables, including your 401(k) makeup, investment time horizon, spending needs, current/future tax brackets and more.
If you’ve discovered a “coupon” with your 401(k), reach out to your Corient Private Wealth Advisor to help you determine whether you should use it.
For more strategies related to NUA, please read the first part of this blog mini-series, “NUA Strategy, Part 1: An Undiscovered Pearl in Your 401(k).”
4 $150,000 * 33% tax rate
ABOUT THE AUTHOR
Eric is responsible for managing client relationships, advising families and individuals on financial planning, tax planning and investment management. In addition, he is also responsible for coordination of service team.
Eric graduated from the University of Illinois at Urbana-Champaign with a degree in Agricultural & Consumer Economics. Prior to joining RegentAtlantic, Eric worked at a Registered Investment Advisor in Kansas City.
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