Some companies offer the benefit of employees owning stock in the employer company through 401(k) plans, profit-sharing plans, stock bonuses and employee stock ownership plans (ESOP). Anyone who owns company stock will eventually have to decide how to distribute those assets when leaving the company or entering retirement. One major thing to consider when doing so is the tax bill that may come along with it. The good news is you may be able to take advantage of a little-known tax break called net unrealized appreciation (NUA) — if you qualify.
What Is NUA?
When you are presented with the option to distribute your assets, you will have the choice to roll them into an IRA or place the stock into a taxable account and then roll the remaining assets into an IRA or 401(k). When you transfer most assets to a taxable account, there will be income tax, but with company stock, you can take advantage of NUA.
NUA is the difference in value between the price initially paid for a stock (the cost basis) and its current market value at the time it is distributed. For example, you retire with 1,000 shares of the company’s stock. You originally paid $10 per share but they are now valued at $50 per share. The difference between those two values, $40, is the NUA and represents the amount applicable to capital gains tax, which is typically lower than ordinary income tax rates.
When utilizing the NUA strategy, you must take a lump-sum distribution of all the assets in the employer-sponsored retirement plan account. The employer stock is distributed in-kind and is usually moved to a brokerage account. The remaining assets may be rolled over. Additionally, you must distribute the entirety of the vested balance held in the plan within the calendar year, including all assets sponsored by the same employer.
“While pretax contributions to a 401(k) or other retirement plan reduce our taxable income in the year of contribution, once we retire and begin distributions, these pretax amounts and subsequent gains will be taxed at ordinary income tax rates that are in effect during each distribution year,” said David Freisner, Wealth Management Advisor at Fortune Financial Advisors. “An exception to this ordinary income tax taxation rule is on appreciated employer securities that are distributed from an Employer Retirement Plan.”
Distributions only qualify for NUA treatment if completed after a triggering event, including:
- Separation from the employer
- Reaching age 59-1/2
If the requirements are met, NUA can be a tax-efficient means of distributing all or a portion of employer stock.
Benefits of Using NUA
Distributing stock out of a 401(k) will have different effects on funds based on IRS rules and regulations. In certain situations, the NUA strategy can offer additional planning opportunities, such as:
- Avoid paying ordinary income tax on a portion or your entire 401(k) balance as NUA gives you the ability to pay tax at more favorable rates than regular income.
- Reduce your assets subject to required minimum distributions at age 72 to improve tax planning opportunities in retirement.
- Flexibility to sell employer stock on your own terms as there are no holding period requirements.
- Accomplish charitable goals by donating the stock using a donor-advised fund.
“What is one of the biggest benefits of the NUA? It’s the taxation angle,” said Freisner. “The appreciation on employer securities that are transferred in-kind to a brokerage account as part of the NUA is not taxed upon the transfer. Shares will only be taxed when later sold and they will receive preferential long-term capital gains treatment. There are multiple approaches on whether to take a full in-kind transfer or select specific lots to transfer or to not take an NUA at all.”
When to Choose NUA
When deciding whether the NUA strategy is the correct fit, there are a few factors to consider:
- Your age: The younger you are, the more time there is for assets you roll over to an IRA to grow on a tax-deferred basis. There is less benefit in taking the NUA tax treatment if you have many years left before retirement as the years of growth in the IRA may outweigh the lower capital gains tax rates on the NUA portion as well as any dividends you receive and will pay taxes on each year.
- Tax rates: A larger difference between the ordinary income tax rate and the long-term capital gains tax rate leads to greater potential tax savings when electing the NUA tax treatment of company stock.
- The NUA amount: If the cost basis is low and the current value of company stock is high, the NUA will be higher making a larger share of distributions eligible for the lower capital gains tax rate.
- The types of retirement accounts you own: If most of your funds are in tax-deferred accounts, NUA tax treatment can help develop a balance between pre-tax and post-tax retirement assets and may result in added tax savings when required minimum distributions begin.
- Your risk: If one company’s stock represents a large portion of your financial assets and you plan on holding it long after distributing it from the plan, it’s important to evaluate the investment risk. Having a diversified portfolio with different investments reduces the overall risk profile.
Potential Downsides of NUA
Even though utilizing NUA can be an effective tax-minimizing strategy for some, there are situations when it doesn’t make sense. Forbes mentions:
- Concentration risk: With stock options, restricted stock units, employee stock purchase plans and other types of equity compensation, voluntarily adding to the position in a retirement plan doesn’t always make sense. Diversifying company stock may have tax implications and you are already in the most vulnerable position financially at the beginning of retirement.
- Tax savings don’t materialize: If your tax bracket at the time of electing NUA is higher than what it will be in retirement, you could end up paying more tax.
- Trigger other changes to your tax situation: Depending on your taxable basis in the stock, recognizing a large amount of income could trigger the 3.8% Medicare tax, which applies to income and capital gains.
- No step-up in basis on NUA portion at death: When most taxable assets are inherited, they receive a step-up in basis to the fair market value on the date of death, meaning your heirs could sell the stock and pay no tax at all. However, when NUA is inherited, it does not receive a step-up in basis. Rather the NUA is treated as income and taxed to beneficiaries as ordinary income.
When the company stock assets in your 401(k) are distributed, you are required to pay ordinary taxes on the distributed amounts. NUA is a tax strategy that can help you effectively pay lower capital gains rates rather than the typically higher ordinary income rates. This strategy is most effective if you are nearing retirement age, if you hold highly appreciated company stock and if future tax rates are predicted to increase.
Turn to the Experts at Fortune Financial
There are situations where it makes sense to use the net unrealized appreciation strategy to hold employer stock in your 401(k) and other times where it doesn’t. For more information on tax planning opportunities, please get in touch with a Fortune Financial Advisor. We have a strong history of identifying investment opportunities that build wealth for our clients and can help determine the best option for you. Also, make sure to follow our YouTube channel or other social media accounts for more financial planning tips.
This material is provided for educational purposes only and does not constitute investment advice. The information contained herein is based on current tax laws, which may change in the future. Fortune Financial Advisors cannot be held responsible for any direct or incidental loss resulting from applying any of the information provided in this publication or from any other source mentioned. The information provided in these materials does not constitute any legal, tax or accounting advice. Please consult with a qualified professional for this type of advice. The information provided above is obtained from publicly available sources and is reliable. However, no representation or warranty is made as to its accuracy or completeness.