Planning Details for NUA: A Tax-Saving Strategy

In many large businesses, it’s common for employees to own stock in the company. Anyone who owns company stock will eventually have to decide how to distribute their assets — typically when there is a job change or retirement involved. 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 net unrealized appreciation (NUA). 

To recap, 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. Distributions only qualify for NUA treatment if completed after the triggering event (separation from service, reaching retirement, death or disability). In addition, shares of employer securities for the NUA must be moved in-kind to a taxable brokerage account. You cannot sell the securities within the retirement plan, then move cash to a brokerage account and purchase the same shares at that point. This would negate the NUA benefit. The analysis of how much, if any, of the employer securities within a retirement plan to elect NUA treatment is a unique decision based on three things: projected annual retirement needs, projected future marginal tax rates and estate planning considerations.

Watch to Learn More About General Rules Surrounding NUA

Cost Tradeoff

The tax deferral within a retirement account is a powerful accelerant for wealth accumulation, as both dividends and capital gains are not taxed when received each year as they would be in a taxable brokerage account. However, the tax deferral benefit comes at a cost tradeoff. Almost every dollar distributed from a pretax retirement account will be taxed at ordinary income tax rates. These rates are almost always higher than those on dividends and capital gains. While within a taxable brokerage account, both dividends and capital gains generally receive favorable tax treatment. But, they are nonetheless taxed when received, which can reduce overall returns due to the taxes owed on these. 

Another major point is that the retirement plan must be empty within the calendar year as a lump sum distribution. For example, if you are planning to retire in November or December of a future year, we strongly recommend you don’t initiate any distributions until the following January. The reason for this is if there is a delay in processing the transaction, you run the risk of the retirement plan not being fully liquidated before December 31, which will negate the NUA treatment and can leave you with a large tax liability on the full amount of the distribution. 

Watch to Learn More About Selecting Specific Lots for NUA

Examples of NUA Taxation 

Let’s look at two examples of NUA taxation based on the sale of employer securities post-NUA transfer date. These two examples result in separate taxation rules based on their dates of sale and highlight the need to incorporate tax planning in NUA decisions.

Example 1: This example involves 100% NUA election of employee security into a taxable brokerage account. Assume you decide to sell 200 shares on the same date as the NUA transfer was completed. Stock A on that date is $50 per share and the cost basis is $10 per share. The taxation for 200 shares of Stock A would have been $8,000 in long-term capital gains ($50 market price – $10 cost basis x 200 shares).

Example 2: You decide to wait three months until after the NUA transfer to sell those same 200 shares of stock A, which has risen to $55 per share on the date of the sale. In this case, the taxation would include both long-term and short-term capital gains. The long-term would be $8,000, which is the difference between $50 on the NUA date and the $10 cost basis. The short-term would be $1,000, which is the $5 growth since the NUA date. This short-term gain would be taxed at ordinary income tax rates. The reason for the short-term is that any changes in market prices after the NUA date resets the holding period rules. One year or less is short-term capital gains and one year plus one day or more is long-term capital gains. In this example, if you would have waited to sell until one year and one day after the NUA date, that $1,000 would be taxed at long-term capital gains rates. 

NUA Tax Implications

Sections of our U.S. Tax Code can be utilized to reduce the tax bite on an NUA election, specifically the language contained in Section 402. Section 402(c)(2)(b) states that in the case of a transfer (rollover): 

such portion is transferred to an eligible retirement plan, the amount transferred shall be treated as consisting first of the portion of such distribution that is includible in gross income (determined without regard to paragraph (1).

So, what exactly does this mean for an NUA and why is this important to consider in any NUA elections that a client makes? Overall, this Section of the Tax Code provides that in the case of a distribution that is partially rolled over to an IRA, the rolled portion “shall be treated as consisting first of the portion of such distribution that is included in gross income … ” This can be a great planning opportunity for an NUA election because as the US Tax Code states, the cost basis (taxable portion) will be the first amounts that are distributed from a retirement plan such as a 401(k) that includes employer securities in the plan. 

For example, you have the following employer securities in your retirement plan: 12,000 shares of Company A stock valued at $80 per share, for a current value of $960,000. The cost basis of these 12,000 shares is $30 per share, for a total of $360,000. To move all 12,000 shares in-kind to a brokerage account and leave them there would incur ordinary income taxes on the $360,000 of cost basis. However, since the U.S. Tax Code states and was upheld by the IRS in a Private Letter Ruling, an approach would be to transfer in-kind all the employer stock to a brokerage account. Remember, the “rolled” portion “shall be treated as consisting first of the portion of such distribution that is included in gross income.” Once the shares are transferred in-kind to the brokerage account, you have a 60-day window to roll over the cost basis (taxable portion) into an IRA. This eliminates the ordinary income taxes on this amount because it has been rolled over. The cost basis of the shares remaining in the brokerage account would now be $0, saving more than $100,000 in federal taxes.

Turn to the Experts at Fortune Financial

The experts at Fortune Financial offer decades of experience turning visions and dreams into sound financial realities. We offer a full spectrum of financial planning and wealth management services that are tailored to your personal, business or retirement plan goals. 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 options for you. Also, make sure to follow our YouTube channel or other social media accounts for more financial planning tips.

Important Note

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.