I’ll never forget the conference call I had with a client who was getting ready to retire from the company she had worked for 20-plus years. She had saved as much as life had allowed her to, and most was invested in the stock of the company which employed her all that time.
Almost Pulled The Trigger…. We were ready to give the instructions to do a 401(k) Rollover right before we learned that her cost basis in the stock was very low and she had an NUA (Net Unrealized Appreciation) opportunity to consider.
Upon learning that, we put it on hold, and I had the luxury of trying to explain what Net Unrealized Appreciation rules were over the phone. If you don’t know, explaining NUA rules over the phone is not the wisest decision.
Not having the visual benefit of really snazzy flow charts makes it very difficult. In a real way, net unrealized appreciation has to be seen to be fully appreciated.
What is Net Unrealized Appreciation Anyhow?
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What is this NUA, you ask? NUA is a favorable tax treatment on employer securities (usually stock) for lump-sum distributions from a qualified retirement plan.
More and more companies are offering employer stock as an investment option inside their qualified plans, allowing NUA to provide a potentially lower tax bill.
The net unrealized appreciation is the difference between the average cost basis of the shares of employer company stock that has been purchased over the years when it was accumulated and the current market value of those shares.
IRC 402 allows employees to take a lump-sum distribution of their qualified plan, pay ordinary income tax on a cost basis, and then pay long-term capital gains on the growth, even if they sell it the same day. Does this sound too good to be true?
It’s actually an excellent way to take distributions on highly appreciated company stock. It may even be a more advantageous way of taking a distribution on the stock than rolling it over into another retirement plan, like an IRA – at least in certain cases.
Qualifications For NUA To Work:
In order to set up an NUA, there’s a long list of requirements that must be met:
- The employee must take a lump-sum distribution from the retirement plan.
- No partial distributions are permitted – the lump sum distribution must take place within one year of a) separation from your employer, b) reaching the minimum age for distribution, c) becoming disabled, or d) being deceased.
- The distribution must include all assets from all accounts sponsored by and held through the same employer
- All stock distributions must be taken as shares – they cannot have been converted to cash prior to distribution.
- The entire vested interest in the retirement plan must be distributed.
- The employee may be subject to a 10% penalty for premature distribution if he or she is under age 59 ½ unless the employee meets an exception to the premature distribution penalty under section 72(t).
- The cost basis is the Fair Market Value (FMV) of the stock at the time of purchase, regardless of whether the employer or employee contributed the money.
- The NUA does not receive a step-up in basis upon death, it is instead treated as income in respect of a decedent.
- If there is any additional gain above the NUA, the long-term/short-term capital gains will be decided by looking at the holding period after distribution.
- No Required Minimum Distributions (RMDs) are required
In addition, you can only do an NUA if the employer company stock was originally purchased and held in a tax-deferred account, like a 401(k). The NUA only applies to the stock of the employing company, which means the benefit is not available for individual stocks of non-employer companies you may have held in your account.
Roth IRA limitation. Roth IRAs don’t qualify for NUA treatment because they are not tax-deferred, and brokerage accounts do not qualify because they are generally subject to the capital gains tax anyway.
There are three long-term capital gains tax rates, and they are based on your ordinary income tax bracket as follows:
- If your income is between $0 to $41,675 (single) or $0-$83,350 (joint), your long-term capital gains rate is 0.
- If your income is between $41,676 – $459,750 (single) or $83,351 – $517,200 (joint), your long-term capital gains rate is 15%.
- If your income is over $459,750 (single) or $517,200 (joint), your long-term capital gains rate is 20%.
How is the NUA more advantageous than simply keeping the stock in the employer plan, then doing a direct rollover into an IRA? It all depends on your ordinary income tax bracket, the cost basis of your stock, and your current need for the money.
When an NUA Works Better than a Rollover
Let’s say that you’re in the 15% income tax bracket – which also means that any long-term capital gains that you incur will be in the 0% long-term capital gains tax bracket. You have $100,000 in the 401(k) of a former employer, $20,000 of which is in employer stock.
The stock was purchased at a total cost of $4,000, which means that they now reflect a gain totaling $16,000. You have $80,000 of the 401(k) – the non-employer stock portion – rolled over into a self-directed IRA, completely shielding it from income taxes.
But you may have an immediate need for at least some of the 401(k) money, so you take delivery of the employer stock, or more specifically, you have them transferred to a taxable investment account where they can be liquidated on short notice.
Though the stock has a total value of $20,000, only $4,000 of it – your cost basis in the stock – is subject to income tax. Since you’re in the 15% ordinary income tax bracket, only $600 of the $20,000 transfer must be paid for taxes ($4,000 X 15%).
Should you decide to sell the stock, you will realize a $16,000 gain.
But since you’re in the 0% bracket for long-term capital gains, there’s no tax liability due on the sale of the stock. In this way, you are able to gain immediate access to the proceeds from the sale of $20,000 in employer stock from your 401(k) plan for just $600.
That works out to be just 3%. If you have an immediate need for the funds, this would be a highly tax-efficient way to gain access to them.
By contrast, were you to also roll the employer stock into an IRA, and you needed $20,000 immediately (or any portion of it), the distribution from the IRA would be subject to your 15% ordinary income tax rate.
That means that you will pay $3,000 on the distribution, compared to just $600 using the NUA.
When a NUA Doesn’t Work Better Than a Rollover
An NUA won’t make sense if you’re in a higher tax bracket and there’s less of a gain on the value of your employer stock. Let’s say that you’re in the 25% ordinary income tax bracket, which means that long-term capital gains are taxed at 15%.
Let’s say that your employer stock is currently worth $20,000, but it has a cost basis of $15,000. If you take an NUA on the stock, $15,000 will be taxable at ordinary tax rates or $3,750 ($15,000 X 25%).
You sell the stock, at which time the $5,000 gain is subject to your long-term capital gains rate of 15% or an additional $750. Your total tax liability is $4,500, or 22.5% of the value of the $20,000 stock position. That’s a bit less than the 25% you’d pay if you rolled over the stock into an IRA and later withdrew the money.
But if you don’t have an immediate need for the money, and you anticipate being in the 15% tax bracket in the near future, you might avoid the NUA and just do a full rollover of the stock along with your other 401(k) funds.
This treatment will defer taxes of already ordinary income assets and allow the employee to experience favorable long-term capital gains rates on the appreciated stock.
Is taking advantage of Net Unrealized Appreciation worth it?
The main consideration when exploring NUA is the ability of the employee to pay income tax on the basis of the stock in the year of distribution. If the employee has considerable gains in the stock, NUA may be a viable option to pay lower taxes on the sale of the stock.
Rolling over the qualified plan does allow the employee to defer taxes to a later date, but at the expense of missing the opportunity, NUA offers to have some of the income taxed as long-term capital gains.
Without NUA, the entire amount will be taxed on the distribution as ordinary income. What that equates to is a whole lot of tax you did not have to pay.