The Dow Jones Industrial Average is approaching another all-time high. Eventually, the market reaches a new peak, rewarding those investors who were patient and especially those who continued to invest during a downturn. Investors who added money to their company 401(k) and bought their company stock while it was low have an added tax advantage. This can be a significant benefit to keep in mind when retiring.
The best way to explain this technique is to tell you the story of Rodney Hartwell, whose stock distributions from his tax-deferred retirement plan were not structured in the most tax-efficient way possible:
Case Study: Rodney Hartwell, medical supply executive
Rodney Hartwell, an executive at a medical supply company, was planning on retiring at year-end. Rodney had $100,000 worth of employer’s stock held in the company’s 401(k) plan with a cost basis of $20,000. A local investment adviser recommended Rodney roll his company stock into a low-cost IRA, explaining the advantages of the IRA and telling Rodney his account would grow larger because the tax would be deferred—and there was also the likelihood of potential returns with the hot mutual fund he just happened to be recommending for the IRA.
The advice this investment adviser gave Rodney wasn’t unusual, since tax-deferred savings accounts are most people’s go-to method of saving for retirement. The book Don’t Retire Broke: An Indispensable Guide to Tax-Efficient Retirement Planning and Financial Freedom, points to a likely problem with keeping everything in tax-deferred accounts. Every dollar a retiree wants to spend will be taxable when withdrawn from the account.
This adviser failed to explain the downside of saving everything in a tax-deferred account to Rodney. All of his IRA withdrawals are taxed at ordinary income rates (currently as high as 37%), including the $80,000 gain on his company stock.
The adviser should have discussed with Rodney an often-overlooked tax strategy known as net unrealized appreciation (NUA). How does an NUA work? Here’s an example. An employee is about to retire and qualifies for a lump-sum distribution from a qualified retirement plan. He elects to use the NUA strategy, receives the stock, and pays ordinary income tax on the average cost basis, representing the original cost of the shares. This strategy allows tax to be deferred on any appreciation that accrues when the stock is distributed until it’s finally sold.
Note the NUA distribution must be taken as a lump-sum distribution, not a partial lump-sum distribution. To qualify for a lump-sum distribution, the employee must take the distribution all within the same calendar year.
The NUA strategy would have allowed Rodney to receive an in-kind distribution of his company’s stock and pay income tax only on the shares’ average cost rather than on the current market value. In that case, Rodney’s tax on the $80,000 gain would be treated as long-term capital gains and taxed at a maximum of 15% (20% for high-income taxpayers). This change alone could result in a potential tax savings of $12,000. (The $20,000 cost basis is still taxed as ordinary income.)
Five Steps to a Successful NUA Transaction
Before exercising a distribution or rollover, follow these five steps designed to help you understand what it takes to complete a successful NUA transaction.
1. Start early
The NUA transaction may take several weeks. Make sure you obtain a written copy of your cost basis before initiating the rollover. You can get formal documentation of the cost basis of the company stock; you can also request official documentation showing your employer’s promise to make an in-kind distribution of the company shares.
2. Determine the amount of gain in the stock price
In an employer-sponsored retirement plan, you can elect an NUA on some, all, or none of the shares. Take note, however, on shares you bought for more than the current stock price; it’s not logical to elect this strategy. Instead, seek out shares that are currently selling for twice your cost basis.
3. Select the sequence of transactions when the plan holds other assets in addition to employer securities.
You can transfer the company stock portion (which still qualifies for the tax break on the NUA) to a taxable (non-IRA) brokerage account, and you can roll the non-company stock portion of the plan into an IRA rollover account. It would be best if you executed the IRA rollover first for all assets except the company stock, then the NUA shares can be distributed in-kind, with nothing to withhold for the IRS from either transaction.
Note: unless it’s a trustee-to-trustee transfer, or the only remaining asset being distributed is employer stock, your employer should withhold 20% of distributions from a qualified plan for taxes.
4. Know your liabilities
It would be best if you had your tax professional prepare a tax projection to determine the amount needed and be prepared to pay the taxman in April.
5. Prepare an exit strategy
Assuming you’re optimistic about your company’s future and proceed with the in-kind distribution, you should still have an exit strategy if it starts to decline. One possibility is to give some stock to a charitable remainder unitrust (CRUT). Once the stock is transferred to a CRUT, the shares can be sold by the trustee and reinvested in a diversified portfolio that can provide lifelong income to the donor. The charitable deduction might even offset most of the tax obligation on the cost basis.
A few words of caution before you jump on the NUA bandwagon.
First, an NUA distribution may not be a good idea if the company’s outlook is bleak. The tax benefits are wasted if the company stock declines significantly after the distribution. An investor with 98% of his retirement account tied up in one stock may want to consider liquidating a portion of his stock position and distributing a smaller part of the stock in-kind.
Second, never ask for in-kind distributions of company stock in December. It’s better to wait until the beginning of the next year because the entire distribution (rollover and in-kind distribution) must be completed in the same calendar year.
Insights
- If you own large quantities of company stock inside a retirement plan, you should know about Net Unrealized Appreciation (NUA).
- NUA allows the tax to be deferred on any appreciation that accrues from the time the stock is distributed until it’s finally sold.
- All retirement income will be taxable if all your retirement savings are in tax-deferred accounts.
