Retirees who own their employer’s stock in their 401(k) plan have the potential for huge tax savings using 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, which represents the original cost of the shares. This strategy allows the tax to be deferred on any appreciation that accrues from the time 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, and in order to qualify for a lump sum distribution, the employee must take the distribution all within the same calendar year.
The strategy isn’t quite as advantageous as it once was prior to the American Taxpayer Relief Act of 2012 (ATRA12) and the Medicare Surtax of 3.8% on net investment income. Both of these tax laws took effect in 2013 and generally impact taxpayers with income over $250,000. ATRA12 raises the rate on long term capital gains from 15% to 20% for taxpayers with income over $450,000. The Medicare Surtax affects capital gains but distributions from a retirement account are exempt. Those taxpayers affected by these changes will need to review the NUA strategy carefully to determine if it still makes sense.
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. Be sure to obtain a written copy of your cost basis from the plan sponsor before initiating the rollover. You should also request formal 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. As a rule-of-thumb, you only want to use this strategy on shares 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) investment account, and you can roll the non-company stock portion of the plan into an IRA rollover account. You should execute 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 that unless it’s a trustee-to-trustee transfer, or the only remaining asset being distributed is employer stock, your employer is required to withhold 20% of distributions for taxes.
4. Know Your Liabilities. You should have your tax professional prepare a tax projection to determine the amount needed, and be prepared to pay the IRS 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 the stock starts to decline. One possibility would be to give some or all of the stock to a charitable remainder trust (CRT). Once the stock is transferred to a CRT, 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.
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 their retirement account tied up in one stock may want to consider selling a portion of the stock position with the highest cost. Use the NUA strategy to distribute a smaller portion of the stock in-kind. Second, never attempt to complete an NUA distribution late in the year. 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.
- NUA allows the tax to be deferred on any appreciation that accrues from the time the stock is distributed until it’s finally sold.
- Distributions must be taken as lump sum distributions, not partial lump sum distributions.
- In order to qualify for the NUA treatment, an employee must complete the entire distribution within the same calendar year.