Roth Conversions and Net Unrealized Appreciation

As you approach and enter the first year of retirement, two strategies are often worth considering, especially since there is a small window during which their productivity would be maximized.

1. Roth Conversion
2. Net Unrealized Appreciation (NUA)

Roth Conversions

In 2025, the contribution limit for Roth IRAs is $7,000 (or $8,000 if over the age of 50), and the ability to contribute the full amount begins to be phased out at modified adjusted gross income (MAGI) of $230,000. If you do not have any Roth assets or believe that it would be beneficial to have more of your assets in a Roth account (as opposed to traditional or pre-tax), you may be a good candidate for a Roth conversion.  

Fundamentals of a Roth Conversion: A Roth conversion involves taking a distribution from your traditional IRA and rolling it over into a Roth IRA. When those dollars are withdrawn from the traditional IRA, they will be taxed at ordinary income rates (assuming no after-tax contributions were ever made). They could even push you into a higher tax bracket. Because of this, it is prudent to discuss with your accountant (CPA) to determine the dollar amount you could pull from the IRA to stay within your current tax bracket, and perhaps do several distributions (conversions) over a few years to remain in a lower tax bracket.

Roth Conversion Checklist

If you review this checklist and can check one or more of these options, you may be a good candidate for a Roth conversion:

1. You believe you will be in a higher tax bracket later
2. You have sufficient taxable assets to pay the taxes from the conversion
3. You wish to eliminate or reduce the amount of required minimum distributions
4. You have a reasonably long time horizon until distributions from the Roth IRA (min. 5 years)
5. You wish to pass assets tax-free to heirs  

Traditional IRA dollars are taxed at ordinary income rates when distributed in retirement. These IRAs also require that you begin minimum distributions (RMDs) either at age 73 or 75, depending on the year. If you believe you are in a lower tax bracket now than you will be later, you are essentially pre-paying taxes at a lower rate by doing a Roth conversion. (You could be in a higher tax bracket due to either increased income or legislative changes to tax law.)

To maximize the effectiveness of a Roth conversion, you would need to have sufficient non-retirement assets to pay the tax liability owed on the conversion without dipping into the retirement assets. For example, if you convert $50,000, you owe $18,500 in taxes, and you pay the $18,500 from the retirement assets, then you only end up converting $31,500. In this scenario (paying taxes from the IRA dollars), the effectiveness of the conversion has been reduced due to a lower net amount funded into the Roth IRA.  

The best time to consider a Roth conversion would be immediately following retirement (no employment income), but before initiating your social security benefits and before RMDs start. This may be the lowest tax bracket that you have been in since starting your career, or will be in for the rest of your retirement. If this period spans 3-5 years, it could be highly beneficial to initiate an annual Roth conversion to pre-pay taxes on those dollars at a lower rate, reduce the amount of pre-tax dollars that will be forced out through RMDs, benefit from long-term tax-free growth in the Roth IRA for expenses later in retirement, and establish a tax-free account that can be passed to heirs if it is not needed for retirement.  

Net Unrealized Appreciation (NUA)

The timing of a Net Unrealized Appreciation (NUA) distribution aligns with the Roth conversion discussion because it must be considered in the year leading up to retirement, and/or the year of retirement. NUA strategies are oftentimes considered by long-term employees who have a significant portion of their 401(k) assets invested in their company’s stock.

While some 401(k) plans offer a Roth option within the 401(k), it is more common that you see employer stock allocated to the pre-tax portion of the 401(k). The NUA strategy in this article assumes this to be the case.   When these dollars are withdrawn from the 401(k) in retirement, they are taxed at ordinary income rates (not capital gain rates, which are lower).  

If, for example, you had invested $100,000 throughout your career in your employer’s stock, it would have appreciated to $500,000. Then you began liquidating it to withdraw from the 401(k), and the entire $500,000 would be taxed at ordinary rates. NUA, on the other hand, is a special provision that would provide some concession regarding the taxation of unrealized gains on company stock. The basis in the stock ($100,000 in this example) is still taxed at ordinary income rates. The appreciation, on the other hand, ($400,000) is not taxed when it is distributed from the 401(k). When the assets are liquidated, they are taxed at long-term capital gains rates (together with any post-NUA appreciation that qualifies), which are lower than ordinary income rates. The strategy for someone, for example, who was married filing jointly and in a 32% tax bracket would be to pay 15% in tax on the $400,000 in unrealized gains instead of the 32% tax rate. (Capital gains rates can range from 0% to 20% depending on income.)

There are several qualifications to meet to successfully execute an NUA strategy, which highlights the importance of discussing the strategy with the plan administrator and your CPA (some of these qualifications are: attained the age of 59 ½, disabled, separation from service, or death). It is also the case that the entire vested balance of the 401(k) would have to be distributed; however, the amount not distributed via NUA could be rolled over to an IRA.  

The immediately noticeable benefit to NUA (as outlined in the example above) is that you would be paying the lower capital gains rates on the company stock’s appreciation instead of ordinary income rates. The drawback of NUA is that the employer stock selected for NUA treatment is now growing outside the tax-sheltered bounds of the 401(k) or IRA, which means it will no longer benefit from tax-deferred growth. If the intention is to hold the stock for a long time, this may not have significantly adverse effects, since unrealized appreciation is not taxed and is essentially tax-deferred; however, if the intent is to diversify out of the stock and actively trade for the duration of retirement, then the tax-deferral of the 401(k) (or IRA if rolled over) could be worth considering (as an argument not to do an NUA distribution). (Of course, if the stock pays a dividend, that dividend will also be taxed every year, as opposed to accumulating on a tax-deferred basis in the 401(k) or IRA.)  

Please consult with your plan administrator, CPA, and financial advisor before initiating an NUA strategy.