If you hold company stock within your employer-sponsored retirement plan, you may be eligible to take advantage of a valuable tax planning strategy called net unrealized appreciation (NUA).
NUA refers to the difference between the cost basis of employer stock and the stock’s current market value. The NUA tax benefit allows investors who hold company stock in a qualified workplace retirement plan to qualify for capital gains tax treatment on the investment gain when they sell that stock, rather than the ordinary income tax rate that typically applies to retirement plan distributions.
How does NUA work?
Typically, when you withdraw assets from a qualified retirement plan (such as a 401k, 403b, IRA rollover account), the amount withdrawn is taxed as ordinary income based on your income tax bracket. Should a withdrawal be made from an IRA rollover account prior to age 59.5, then the distribution from an IRA rollover may also be subject to a 10% excise tax. In contrast, stock held within a taxable investment account for more than one year is subject to more favorable capital gains tax rates. So, what about company stock held within a qualified retirement plan? If standard distribution rules are followed, company stock investment gains would be subject to ordinary income tax rates when the stock is eventually sold to fund an individual’s retirement expenses.
Fortunately, the IRS allows taxpayers to access the more favorable capital gains tax rate when they sell company stock to pay for their retirement expenses. NUA refers to the process of accessing this tax benefit.
For example, let’s say Stacy used pre-tax funds to purchase 1,000 shares of company stock within her 401k plan for $100 per share, meaning she invested $100,000 in company stock. Ten years later, her shares are worth $250 each, which means her total company stock value is $250,000. Of that $250,000, $100,000 is Stacy’s cost basis and $150,000 is her NUA.
Stacy is now 62 and has retired from her company. She decides to take advantage of the NUA tax benefit by requesting an in-kind transfer of her company stock to a taxable investment account. At the time of the transfer, she is responsible for paying income tax on the stock’s cost basis ($100,000) at her income tax rate of 35%, which equals $35,000 in income tax. She later decides to sell the shares and is taxed at a long-term capital gains tax rate of 15% on the NUA, paying $22,500 in taxes. Had she sold the company stock within her retirement plan and taken a distribution directly to herself, she would have paid ordinary income tax on the entire amount, equating to $87,500. Instead, her total tax liability was $57,500, a savings of $30,000.
NUA qualifying criteria
In order to qualify for the NUA tax benefit, you must meet all four of the following criteria.
- Distribute your entire vested retirement account balance within one year. You can request multiple rounds of distributions, but you must completely liquidate the account within one year.
- Distribute all assets held within all qualified plans of the employer, even if you only hold company stock in one of the plans.
- Distribute company stock as in-kind shares. You will not qualify for NUA treatment if you sell the shares prior to the distribution.
- Experience a qualifying event, such as:
- Retiring or terminating from the company that sponsors the plan
- Reaching age 59.5
- Experiencing a total disability (if you are a self-employed worker)
- Death
Additional considerations
Before attempting the NUA strategy, it’s important to consider the following:
- You may be subject to a 10% early withdrawal penalty on the cost basis of the stock if you have not yet reached age 59.5 by the time you distribute the assets.
- Not all plan administrators calculate cost basis in the same manner. For example, some administrators calculate an “average cost per share,” while others track the cost of each specific lot. The method of calculation can impact your decision about what distribution strategy makes the most sense for your particular situation.
- If a significant portion of your wealth is invested in company stock, it’s important to have a tax-efficient diversification strategy in place. Your financial advisor can help you implement a strategy that is in line with your overall financial goals.
Successfully executing NUA is a complex process with both tax and financial implications, which is why it is important to work with an experience financial advisor who can guide the process and help you avoid potential pitfalls.
Could you use help with your NUA strategy? We would love to have a conversation. To learn more about how United Capital can help you plan for the future, please contact us.
