Net Unrealized Appreciation (NUA)
Do you work for a public entity that contributes company stock to your retirement plan? Are you aware of the potential tax-free or reduced-tax way this could benefit you in your post-career years?
How much more could your retirement funds stretch if you were able to reduce your taxes on withdrawals from as high as 39.6% to maybe 0%?
Curious how this could be given the fact all distributions from a pre-tax retirement account are taxed at your ordinary marginal tax rate. The good news is that US tax laws contain a rule (IRC Section 402(e)(4) that could provide huge tax-saving benefits during your retirement years by converting some (maybe all) of your retirement assets from ordinary income taxes to capital gains.
This Code Section provides guidance on what is known as Net Unrealized Appreciation (NUA). So, what exactly is NUA? NUA is simply the difference between the stock’s cost basis and its current market value. As an example, it you purchase a stock for $100, and three months later the stock is now worth $120, you have Unrealized Appreciation of $20 ($120 – $100).
How does this NUA process work? Under IRC Section 402(e)(4), if employer stock inside an employer retirement plan is distributed in-kind as a lump-sum distribution after a triggering event (defined as (a) Death, (b) Disability, (c) Separation from Service, or (d) Age 59-1/2), then the cost basis of the stock shares owned will be taxable as ordinary income. The gains on the stock (the Net Unrealized Appreciation) will be taxable at long-term capital gains rates.
In addition, under IRS Notice 98-24, the NUA will always be taxed as long-term capital gains, no matter the actual holding period of the stock inside the retirement plan (the normal holding period for long-term capital gains is one-year and one day).
So, if the NUA is potentially a good deal for employer stock held in your retirement plan, what are the requirements to qualify for NUA tax treatment? There are three specific requirements that must be met:
- The employer stock must be distributed in-kind. Stock options and other types of phantom stock aren’t eligible for NUA tax treatment. The stock must be transferred in-kind. This makes it difficult for most ESOP plans, as the requirement is to actually transfer shares (or share certificates) out of the account, and most ESOP plans don’t allow for this to occur. You cannot liquate shares at termination and rollover the cash proceeds into a non-qualified (i.e., taxable brokerage) account, as this negates the NUA tax treatment.
- Your employer retirement plan must complete a lump-sum distribution. This means your entire account balance must be distributed in a single tax year. The process would be to move (in-kind) the shares you elect to transfer into a non-qualified account, and the shares you don’t elect NUA tax treatment along with any other investments in your retirement account to be rolled into an IRA or convert to a Roth.
- Note: when you retire could play a role in the timing of the distribution of your retirement plan. As an example, let’s say you retire on December 1st, and you rollover your non-employer stock to an IRA on December 15th. You must also complete the in-kind transfer of your employer stock by December 31st of the same year or your NUA tax treatment will be disallowed.
- The critical component is you must zero out your entire employer retirement plan in the same year you begin any distributions from the plan.
- The lump-sum distribution must be made after a “triggering event” (a) Death, (b) Disability, (c) Separation from Service, or (d) Age 59-1/2.
As stated earlier, upon the NUA in-kind distribution, the cost basis of the shares transferred are taxed as ordinary income. If the NUA is completed prior to age 59-1/2 and not otherwise entitled to an exception, the 10% early withdrawal penalty may apply.
One key point of the NUA rules is that while the entire account must be zeroed by December 31st of the year the distribution is initiated as a lump-sum, there is no stipulation the entire account must be distributed in a taxable event. It’s allowable to take only the NUA stock as an in-kind distribution, and rollover the remainder to an IRA.
While ordinary income taxes occur on the in-kind distribution of the employer stock, the actual Net Unrealized Appreciation (NUA) capital gains tax occurs only upon the sale of the shares. For shares held past the in-kind distribution date that are subsequently sold, any further gains will be taxed at either short-term or long-term capital gains rates based on the holding date between the original distribution date and the ensuing sales date.
What happens on shares held past the distribution date where losses occur on a future sale? The loss amount will simply reduce the amount of NUA gain on the future sale unless the sales price drops all the way down to below the original cost basis. In this instance, a capital loss will be reported.
A main challenge with determining whether to elect an NUA on the distribution is the multiple tax events that will occur at some point, either on the distribution of the shares (ordinary income taxes on the cost basis), and on the future sale of the employer stock (long-term capital gains plus potentially short-term capital gains based on the holding period post-distribution).
Although the NUA strategy does provide the opportunity for tax savings by turning ordinary income taxes on distributions from a retirement account (IRA) into capital gains taxes on the NUA gains, there is much more to the analysis than tax savings.
Some of this analysis includes:
- The percentage of the cost basis v. the market value of the employer stock
- How much income will we need in retirement (hence, will we be in the 15% tax bracket that translates into 0% capital gains taxes on liquidated (sold) shares or in a higher tax bracket that results in a 15% or 20% capital gains rate?
- This is an important question because if our plan is to diversify our employer stock (assuming an NUA strategy), then we will be able to potentially diversify a portion (or all) of our employer stock over time with zero tax impact.
- How much time will pass before we start taking distributions from our retirement funds?
- What other assets will be available to fund our retirement years?
Does a high percentage of cost basis v. the market value of employer stock automatically eliminate the potential benefits of an NUA strategy? The short answer is not necessarily, and here’s the reason. Let’s look at the following scenario.
Jada has plans to retire in January of next year, and has received employer stock shares with a market value of $635,000 inside her profit-sharing plan. These shares have a cost basis of $375,000 (for a gain of $260,000). Jada wants to know the tax impact if she elects an NUA conversion?
Jada would pay ordinary income taxes on the cost basis of the employer stock. Assuming Jada’s marginal tax rate is 25%, the cost basis would generate a tax liability of $93,750 ($375,000 x 25%). In addition, we assume Jada’s long-term capital gains rate is 20%. If Jada sold all her shares immediately upon distribution, it would generate a long-term capital gains tax of $52,000 ($260,000 x 20%).
Jada’s total tax liability would be $145,750 ($93,750 ordinary income taxes plus $52,000 long-term capital gains taxes).
An interesting tidbit when determining whether or not to pursue the NUA strategy is you can select which shares of stock to include in the in-kind distribution of the employer stock. Why is this important?
Let’s look at the same scenario as above with a slight twist.
Jada’s employer stock shares have a market value of $635,000 inside her profit-sharing plan. The early years of employer stock that Jada received have a market value of $300,000 and a cost basis of $75,000 (for a gain of $225,000), while the remaining years have a market value of $335,000 and a cost basis of $300,000 due to the company’s performance issues that minimized share price gains in later years.
Jada wants to know the tax impact if she elects an NUA conversion by selecting only the shares with a cost basis of $75,000 and the rollover to an IRA for the remaining shares.
Jada would pay ordinary income taxes on the cost basis of the employer stock. Assuming Jada’s marginal tax rate is 25%, the cost basis would generate a tax liability of $18,750 ($75,000 x 25%). In addition, we assume Jada’s long-term capital gains rate is 15% under this modified scenario due to her projected lower taxable income. If Jada sold all her shares immediately upon distribution, it would generate a long-term capital gains tax of $33,75 ($225,000 x 15%).
Jada’s total tax liability would be $52,500 ($18,750 ordinary income taxes plus $33,750 long-term capital gains taxes).
This modified scenario results in a tax-savings on the NUA strategy of $93,250 ($18,750 – $145,750). This represents potential retirement funds that have an opportunity for further growth over time.
There are so many variables to include in determining how much (if any) of the employer stock to include in an NUA strategy. A missed or erroneous step will result in the negating of the NUA strategy. In addition, it may result in lost tax savings from the negated NUA conversion and payments of ordinary income taxes well above capital gains rates projected based on the NUA conversion.
Ultimately, it could result in reduced retirement assets that hinder our abilities to live the financial lives we worked so hard to achieve for many decades.
It’s crucial you partner with a wealth management firm that has the knowledge and expertise to guide you through the appropriate NUA decision process given your unique circumstances, and clearly explain each step in implementing your strategy.
That’s where Fortune Financial has excelled for our clients with employer stock in their retirement plan. It’s a Difference that translates into real dollars during your retirement years.
And one that may make the vital distinction between living your retirement dreams v. simply living your retirement years.