401K Rollover Hidden Tax Strategy for Expats. As an expat, you might have a 401K you had with a previous employer. You might not be aware that there is a tax strategy that is available to expats that could save you a lot of money in tax over your lifetime.
Net Unrealized Appreciation Strategy
The name of the strategy is called ‘Net Unrealized Appreciation’. It is unknown because even most advisors don’t know about it.
There are a few rules to follow in order to accomplish it but it can be really tax-efficient for your estate.
Who is eligible?
- You must be able to take a lump-sum distribution from your 401K. Either because you reached 59 1/2, disability or after separation from employment with your previous employer.
- It is only possible to do this strategy if you have company stock from the company you worked for inside your 401K. It can be called ESOP stock inside your plan.
- You will also need to be able to pay income tax on the cost basis of the stock distributed the same year it is distributed.
How does it work?
If you meet the above requirements then you can request a rollover from your 401K plan administrator or custodian. It is really important to know that this strategy can only be done once at the time of the rollover. The reason is that the appreciated company stock will be transferred to a standard brokerage account while the rest of the assets will be moved to an IRA. This distinction needs to be explained.
Since the stock is leaving a tax advantage plan it has to be taxed accordingly. The cost basis amount will be added to your taxable income for the year. If it is a large amount, you have to be ready to pay a high tax bill that year. It might be wise to time the transfer on a year with a lower income.
You have a 401K worth $1 000 000, with $500 000 of company stock. That stock was acquired many years ago at a cost of $100 000. If you use the Net Unrealized Appreciation strategy you would move $500 000 to tax-deffered account (IRA).
It keeps the tax-deferred growth. You would at the same time move the $500 000 of company stock into a standard brokerage account.
When you do your taxes at the end of the year you will get a 1099 form. Then add $100 000 to your taxable income that year and pay the taxes owed at that time. It will be at your marginal tax rate.
If your federal marginal tax rate is 37% then it is a $37 000 tax bill for that year. The $400 000 appreciated stock value will be taxed when you sell the stock.
Only at the capital gain tax rate of 0%, 15% or 20% depending on your income. It is important to mention that there is no capital gain tax if you are in the 10% or 12% tax bracket. As an expat you would need to know your US taxable income factoring in the standard deduction for individuals or couples. I would recommend talking to an ex-pat tax advisor since your situation is particular.
One great estate planning strategy is to use the NUA option and keep the stock for donation or inheritance purposes. Under current IRS guidelines, if you hold stocks in a taxable account, the cost basis is raised on the day you pass away. It eliminates the tax bill on all the growth until that day.
That means in the previous example, the $400 000 of growth would be received as an inheritance tax-free if the value at the time of death is the same. Any growth above it would be taxed accordingly. This is a huge benefit to the beneficiaries since will receive the full amount of stock tax-free.
Effect on the Required Minimum Distribution
Another great benefit of the Net Unrealized Appreciation is the removal of the company stock from the amount of Required Minimum Distribution. With a traditional IRA or 401K, you would have a Required Minimum Distribution starting the year you reach 72 years old.
That amount starts at approximately 3.5% of the value of the account on December 31st the year before. The percentage goes up every year and the full amount will be taxed eventually.
By being able to remove the company stock from the IRA value, it reduces the amount you would have to withdraw each year in retirement. It is especially important for people that don’t really need the income and would like to leave tax-free stocks to their kids.
NUA Facts to know
- Can only be done once at the time of the 401K rollover
- Reduces the amount of yearly Required Minimum Distribution at age 72
- Only the cost basis of the company stock is taxable on the year it is done
- Potential Tax-Free stock distribution
- Available to ex-pats that hold a 401K with company stock
Expats living abroad benefit from the same tax-efficient strategies offered in the United States.
At Harrison Brook, we specialize in helping Expats wherever they are currently living with great investment strategies that take into consideration the tax implication.
If you have a 401K held by a custodian in the United States and you reside abroad it would be a great idea to review your situation and see how we can bring value to your investment accounts. Don’t hesitate to get in touch.