Tax Savings Opportunity: How After-Tax Retirement Plan Contributions Enhance Your Net Unrealized Appreciation Strategy

If you hold concentrated stock inside an employer-sponsored retirement plan, you may be sitting on a meaningful tax opportunity — and a potential tax problem. The same highly appreciated company stock that boosts your retirement savings can also trigger a large ordinary income tax bill when you eventually take distributions to fund your retirement.

One way to manage this challenge is by using a net unrealized appreciation (NUA) strategy to change how this appreciation is taxed over time. In some situations, combining an NUA strategy with after-tax retirement plan contributions can create additional tax savings and more flexibility in how you use your retirement assets.

What Is a Net Unrealized Appreciation Strategy?

Net unrealized appreciation is the difference between the cost basis of employer securities held in a qualified plan and their current market value at the time of distribution. In simple terms, it’s the amount of appreciation embedded in your company stock position inside the plan.

Under specific Internal Revenue Code rules, if you meet the NUA rules and take a qualifying lump-sum distribution that includes appreciated employer stock, you can elect to move the stock out of the plan and into a taxable brokerage account in-kind. In this type of NUA distribution:

• The cost basis of the stock is taxed as ordinary income in the year of the distribution.
• The net unrealized appreciation — the gain above your basis — isn’t taxed until you sell the shares in your taxable account.
• When you later sell the shares, the appreciation  is taxed at long-term capital gains tax rates, which are often lower than ordinary income tax rates.

This split between ordinary income on the cost basis and long-term capital gains on the net unrealized appreciation is the core NUA tax benefit. When executed correctly, this can be a powerful tax strategy for highly appreciated company stock inside a qualified retirement plan.

If you’re considering whether to keep or diversify a large equity position, our piece on leaving a company with concentrated stock can provide additional context.

Basic NUA strategy example

Consider an employee who holds company stock inside an employer retirement account with a current market value of $1 million and a cost basis of $200,000. In this case, the net unrealized appreciation is $800,000.

If the employee executes a qualifying NUA distribution and transfers the employer stock to a taxable account:

• The $200,000 cost basis is treated as ordinary income in the year of the NUA distribution.
• The $800,000 of unrealized appreciation isn’t taxed until the stock is sold in the taxable account.
• When sold, this $800,000 is generally taxed at long-term capital gains tax rates rather than ordinary income rates, assuming the long-term holding period requirements are met.

At the 37% ordinary income tax bracket, the income tax liability on the $200,000 cost basis would be $74,000 (200,000 x 0.37) in the year of the distribution. The $800,000 of net unrealized appreciation would be taxed later at the applicable long-term capital gains rate when the shares are sold. Additionally, state income taxes will be due depending on the residency status of the taxpayer.

While this NUA strategy can generate tax savings over time by converting what would have been ordinary income into long-term capital gains, the required inclusion of the cost basis as current ordinary income can still create a large tax bill in the year of the distribution.

Using After-Tax Contributions to Help Reduce Your NUA Tax Bill

Many employer-sponsored plans allow participants to make after-tax contributions in addition to pre-tax and Roth deferrals. In some cases, these after-tax contributions can be used to help offset the ordinary income generated by your NUA strategy.

Rather than paying the full ordinary income tax bill on your cost basis out of pocket, after-tax dollars already inside your qualified plan can effectively reduce the taxable cost basis associated with your NUA stock. In practice, this can shrink the amount of basis taxed as ordinary income and increase the portion treated as net unrealized appreciation taxed later at long-term capital gains rates.

After-tax contribution example

Return to the earlier example. You hold company stock within your retirement plan with a current market value of $1,000,000 and a cost basis of $200,000.

When you execute your NUA strategy, the $200,000 cost basis is treated as ordinary income in the year of the distribution. At a 37% income tax rate, this would typically produce a $74,000 tax bill in the year you complete the NUA distribution.

Now assume that, in addition to the company stock, you also have $125,000 in after-tax contributions in the same qualified plan. Under current rules, this $125,000 of after-tax money can be associated with the cost basis portion of the distribution. Doing so effectively reduces the taxable basis from $200,000 to $75,000.

In this scenario:

• The taxable cost basis after applying after-tax contributions is $75,000
• Ordinary income tax owed at 37% is $27,750 (75,000 × 0.37)

Compared with the original $74,000 liability, using after-tax contributions in this way reduces your ordinary income tax bill by $46,250 in the year of the NUA distribution.

The remaining $125,000 of basis that was covered by after-tax contributions is treated differently going forward. Any appreciation above the adjusted $75,000 basis — whether that appreciation occurred inside the plan or after the stock moves to your taxable brokerage account — will generally be taxed at long-term capital gains tax rates when you sell the shares, assuming the long-term holding period requirement is met.

If the portion of appreciation associated with that $125,000 is taxed at a 20% long-term capital gains rate instead of a 37% ordinary income rate, the tax on that piece of appreciation drops from $46,250 (125,000 × 0.37) to $25,000 (125,000 × 0.20), saving an additional $21,250.

Benefits of Combining After-Tax Contributions With Your NUA Strategy

By using after-tax contributions to offset part of your NUA cost basis, you may be able to unlock several important tax benefits.

A lower current-year tax bill

Applying after-tax contributions to your cost basis can sharply reduce the ordinary income tax generated by the NUA distribution in the year you execute the strategy.

Greater use of long-term capital gains tax rates

By lowering the amount of basis taxed at ordinary income rates, you increase the amount of appreciation that’s ultimately taxed under more favorable long-term capital gains rules, which can lead to significant tax savings on highly appreciated company stock.

More flexibility with remaining retirement assets

Coordinating after-tax contributions with your NUA stock distribution can also create flexibility for the rest of your retirement savings.In many cases, you can roll over the remaining pre-tax and Roth retirement plan assets to an IRA while isolating the employer stock for NUA treatment in a taxable brokerage account.

For more ideas on managing tax exposure from appreciated assets, you may also find value in our overview of qualified small business stock’s unique tax opportunity and our guide on maximizing your savings with tax-loss harvesting.

To better understand the risk side of the equation, you can explore the how and why of diversifying concentrated stock risk.

Important Considerations Before Pursuing an NUA Strategy

While combining an NUA strategy with after-tax contributions can create meaningful tax benefits, this approach isn’t right for everyone. There are several technical requirements and planning considerations to evaluate before moving forward.

Qualifying for NUA treatment

To qualify for favorable NUA treatment on appreciated employer securities, several conditions must be met:

• Qualifying triggering events – You must experience a qualifying triggering event, such as retirement, separation from service, reaching age 59 ½, or experiencing death or total disability.
• The “lump-sum rule” – You must take a lump-sum distribution from the qualified plan in a single tax year. This means fully distributing the entire balance of the plan—including mutual funds, cash and other investments—by December 31 of that year.
• Plan recordkeeping hurdles – The employer stock must be distributed in-kind to a taxable account; the plan administrator shouldn’t sell the stock inside the retirement account prior to distribution.

Because these NUA rules are specific and time-sensitive, you’ll want to coordinate the timing of your distribution with your broader tax situation and retirement planning.

Plan design, recordkeeping and risk

Not all retirement plans allow after-tax contributions, and not all plans track cost basis and after-tax contributions in the same way. It’s important to confirm that your plan permits after-tax contributions and that the administrator can clearly identify the basis associated with your employer stock and the amount of after-tax contributions available to offset that basis.

An NUA strategy should also fit within your overall wealth management and investment plan. Keeping a large position in appreciated employer stock in a taxable account exposes you to concentration risk and market volatility. A thoughtful plan might pair the NUA tax benefit with a staged diversification strategy that gradually reduces your concentrated position over time while still taking advantage of long-term capital gains treatment.

Is an NUA Strategy Right for You?

Successfully implementing a net unrealized appreciation strategy — especially one that incorporates after-tax contributions — is a complex process with both tax and financial planning implications. It requires careful analysis of:

• Your current and projected income tax brackets
• The level of net unrealized appreciation in your employer stock and the amount of after-tax contributions available
• Your retirement timeline, cash flow needs and willingness to retain concentrated stock exposure

Because the rules surrounding NUA distributions, basis allocation and long-term capital gains treatment are technical, even small missteps can lead to unintended tax consequences.

Working with an experienced wealth advisor, ideally a CERTIFIED FINANCIAL PLANNER® professional, in coordination with your tax professional can help you evaluate whether a net unrealized appreciation strategy aligns with your overall financial goals and retirement planning.

To explore whether an NUA strategy, or another tax savings strategy for concentrated employer stock, is appropriate for your situation, please schedule a call with Creative Planning.