If you have company stock in your 401k plan, you may want to consider a setting up a tax strategy that takes advantage of net unrealized appreciation (NUA). When done correctly, NUA potentially save you thousands in taxes. On the other hand, you may be surprised at your tax bill for the year if you’re not prepared.
Net unrealized appreciation is the difference between the cost basis of your company stock and the current market value of the shares when being held in the company’s retirement plan account. What a NUA strategy does is allow you to pay the potentially lower capital gains rate rather than the ordinary income rate on the growth of the company stock in your portfolio. There is a trade off when receiving this benefit though.
If you opt to follow the NUA rules, the cost basis of the shares immediately becomes ordinary income for that year. That could lead to a potentially large tax burden. For the strategy to work, IRS rules need to be precisely followed in order to take advantage of the lower capital gain rate. Before you start the process, you need to know the steps, understand your current tax liability, and have an idea of what your future earnings may be.
When to consider a Net Unrealized Appreciation strategy
If company stock that has appreciated significantly, you should consider taking advantage of NUA. The reason is that you would paying the long-term capital gain rate of 0%, 15% or 20% (as of 2018) on the growth of the investment. This is especially appealing consider that a middle-class couple could find themselves paying no taxes on the gains during retirement.
While lowered taxes in the future may catch your attention, you need to keep in mind that there’s an increased tax liability for the year in which the NUA distribution takes place. The cost basis of the shares becomes taxable as ordinary income immediately after the distribution takes place. If the distribution is not considered qualified per IRS rules, there can be an additional 10% penalty on the distribution.
The additional current year tax burden should be considered prior to setting up this strategy. You’ll want to work with your tax professional or financial advisor prior to withdrawing your company stock so that you know how much should be set aside. If the additional taxes are too high for the year, you may want to consider alternatives.
Net Unrealized Appreciation Rules
To begin with, a ‘trigging event’ must occur in order for you to qualify for NUA treatment. These triggering events include death, disability, reaching age 59 ½, or separation from service. If you are still working for the employer, you can only take an in-service distribution for NUA if you become disabled or reach age 59 ½ .
If you qualify, you need the cost basis for your company stock. Many retirement plans will provide this for you. If yours doesn’t, you’ll need to manually calculate the costs of each share (including dividend reinvestments). The cost basis will determine the ordinary income from the NUA distribution.
Once you have determined that amount, you will need to distribute the company stock in-kind. This means that the employer stock is transferred from your retirement account to a taxable brokerage account. The shares need to be either company stock or an employer stock fund that can be converted to stock. Phantom stock cannot be transferred for NUA. You are also prevented from selling the company stock in your retirement plan and then using the cash proceeds to purchase stock in a brokerage account.
Finally, you must take a lump sum distribution from the retirement plan. In the end, the entire balance of your employer sponsored retirement plan will need to be distributed. This needs to be completed by the end of the tax year. No funds can remain in the account at that time.
That means you need to transfer all funds out of your retirement plan. As mentioned, you will transfer your company stock into a brokerage account. However, other investments in the account don’t have to go to the same account as the company stock. Any other investments you hold should go to an Individual Retirement Account (IRA). That means you won’t have to pay taxes on those funds until you take a distribution from it.
Real Life Example
A few months back, someone reached out to me asking about the NUA strategy. He had just turned 59 ½ and had left work at Intel two years prior. Now that he was starting a new job, he was planning on transferring the old 401k account over to his new company. When he tried moving the account, he was told that the new 401k couldn’t hold the Intel stock.
The phone advisor helping with his old 401k mentioned the NUA strategy as a potential way to save on taxes. Like most brokerage firms that handle large corporate retirement accounts, the advisor couldn’t provide much assistance since they didn’t have a complete understanding of the customer’s tax situation. The former employer then reached out to me with questions and asked the following questions:
(1) What is a Net Unrealized Appreciation strategy?
(2) How exactly is it executed?
(3) Does it require lump sum distribution of the full 401(K) or can I take a distribution on the company stock only?
I responded with much of the information you read above. After talking over his situation more, he passed along this information regarding his company stock. A quick calculation illustrated the potential tax savings for them. Based on an estimated cost basis of $45,000 with a current value of $95,000 for I estimated that a NUA distribution saved them around $11,000 over their lifetime.
The strategy would save you approximately $11,000 over your lifetime. At the time of the distribution, he would have needed to pay ordinary income tax on the cost basis of the shares. That meant taxes this year, while he would be paying the lower capital gain rate in the future.
While they would save money in the long run, there a would over $11,000 in additional taxes due this year. They opted against the strategy given the fact that they would need to cover the high tax bill. Luckily for them, they decided to reach out to a financial advisor before deciding to make any changes. While the steps needed to set up the NUA strategy seem simple enough, a thorough review of your financial situation should be completed prior to moving forward.