ELITE ADVISOR BEST PRACTICES
Net Unrealized Appreciation Tax Strategies
NUA rules can be attractive for clients with large amounts of highly appreciated employer company stock—just make sure you know the requirements.
By Tyler DeGroot and Robin Paule
- The net unrealized appreciation rules associated with marketable securities offer a number of tax and investment planning strategies that can result in significant tax savings.
- The NUA rules will be most beneficial to those individuals with a significant amount of highly appreciated employer company stock in a 401(k) who are at or near retirement age and who are able to hold significant amounts of employer company stock and still maintain a diverse retirement portfolio.
- NUA treatment may offer additional efficiencies from an estate and gift tax standpoint, including the opportunity for “stepped up” basis, not otherwise available to securities held in an IRA or other qualified plan.
As corporate executives and highly compensated employees approach retirement, many may want to consider a provision of the tax code that provides tax-favored treatment for distributions of company stock from an employer’s qualified plan such as a 401(k). This provision taxes only the cost basis of the shares of employer company stock when distributed from the 401(k) at ordinary income rates and leaves the net unrealized appreciation, or NUA (the difference between the cost basis and fair market value at the time of the distribution), to be taxed at long-term capital gain rates when the stock is subsequently sold.
Applying the NUA rules may be highly beneficial in the case of executives who have a significant amount of highly appreciated company stock in their company’s qualified plan and doing so creates a number of interesting planning opportunities. First, however, we should examine the requirements needed to qualify for this special provision.
In order to qualify for the special NUA tax treatment, the distribution needs to meet both of the following criteria:
- The distribution must be lump-sum. To qualify as a lump-sum distribution, the distribution needs to be a distribution of the entire balance in the employer’s qualified plan paid out in a single tax year as a result of disability, death, reaching age 59 ½ or separation from service.
- The company stock must be distributed in-kind. The plan cannot liquidate the stock and distribute cash—or roll over the company stock directly to an IRA—and receive the favorable treatment.
Provided these criteria are met, the basic tax consequences will be as follows:
- The cost basis of the employer stock will be taxed at the taxpayer’s ordinary income tax rate in the year of distribution.
- The net unrealized gain in the employer securities will be taxed at long-term capital gains rates, but only when the stock is subsequently sold.
- Any gain in excess of the NUA will be taxed as long term or short term, depending on the length of time the stock is held after the lump-sum distribution occurs.
To illustrate the advantages of using the NUA rule, suppose that a client retired at age 62 and had 10,000 shares of employer company stock in his employer 401(k) plan. Assume the stock is currently trading at $50 per share, resulting in a total fair market value of $500,000 in employer company stock. Also assume that the client’s average cost basis in the stock is $15 per share, or $150,000.
One option is to liquidate the entire amount of the stock and then either withdraw cash from the 401(k) plan or roll the entire 401(k) balance into an IRA. This would result in a taxable distribution of $500,000 that’s taxed at ordinary income rates. In the case of the 401(k) distribution, tax would be due immediately, while the IRA rollover option would allow for deferral of tax, with distributions eventually being taxed at ordinary income rates. Assuming a marginal tax rate of 39.6 percent, the client’s total tax bill would be $198,000.
A second option is to take advantage of the NUA rule by taking a lump-sum distribution of the company stock in-kind. By taking advantage of the NUA rule, the client will pay tax at two different rates:
- The ordinary income tax rate of 39.6 percent would apply to the $150,000 cost basis of the stock, for tax of $59,400.
- Assuming the client immediately liquidated the company stock, the client would pay federal tax at the 23.8 percent (20% federal capital gain rate + 3.8%—assuming they are subject to the net investment income tax) rate on $350,000 ($500,000 fair market value less $150,000 cost basis) of gain, for $83,300 of federal tax.
The total federal tax under the NUA rules in this example would be $142,700, a 27.9 percent savings of $55,300 from the first “standard withdrawal” option above.
State tax treatment of NUA depends on which state your client resides—generally at the time of distribution.
If the employer plan holds other investment assets in addition to the employer company stock, the client should consider making a lump-sum distribution of the entire employer plan and take the company stock in-kind while any non-employer stock is rolled into a traditional IRA. This will allow the client to continue receiving tax-free growth in the IRA until he or she is required to start taking minimum distributions at age 70 ½. Using the facts from our example above, this would result in the cost basis in employer stock of $150,000 being taxed at 39.6 percent, a total of $59,400 in tax, while the tax on any non-employer stock rolled over to a traditional IRA would be deferred until distributions are received.
NOTE: Opting for the NUA distribution treatment may offer both income tax rate benefits to the employee and longer-term family tax efficiencies from an estate, gift and income tax standpoint, since monies transferred from a qualified plan retain their onerous “ordinary” income character when future beneficiaries withdraw any amounts in the future. Conversely, previously taxed retirement funds inherited by spouses or other beneficiaries will generally obtain a “stepped up basis” upon the decedent’s death and will be subjected to significantly lower overall tax burdens when sold or withdrawn.
The strategies above are just a few of the options to consider when applying the NUA rules; many more variations may be possible provided the lump-sum and distribution in-kind rules are met.
The NUA rule offers a number of excellent planning opportunities, but may not be right for everyone. The NUA rule will be most beneficial for those:
- With large amounts of highly appreciated employer company stock
- Who have cash to pay taxes on the distribution
- Who are able to hold significant amounts of employer stock and maintain a diversified portfolio
The NUA rule can offer the alert investment advisor and CPA an excellent strategy to help clients save on taxes and achieve their goals in retirement.