The Dow Jones Industrial Average is approaching its all-time high of 14,000. Eventually it will reach a new high, rewarding those investors that were patient and especially those that continued to invest during the downturn. Investors that added money to their company 401(k) and in particular bought their company stock while it was low have an added tax advantage that they need 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 weren’t 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 advisor 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 advisor gave to Rodney wasn’t unusual, since tax-deferred savings accounts are most people’s go-to method of saving for retirement. But as I mentioned in my book “The New Three Legged Stool”, the major problem with this scenario is every dollar a retiree wants to spend is going to be taxable when he or she reaches for it.
The advisor likely failed to explain the downside of this unfortunate fact to Rodney, and so when his IRA eventually began to distribute income, that income was taxed at ordinary income rates on his $20,000 cost basis and could eventually have been taxed even higher (35%) on his $80,000 gain.
The advisor should have recommended Rodney use 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 NUA strategy would have allowed Rodney to receive an in-kind distribution of his company’s stock and pay income tax only on the average cost basis of the shares, rather than on the current market value. In that case, Hartwell’s tax on the $80,000 gain would be treated as long-term capital gains and taxed at a maximum of 15%, resulting in a potential tax savings of $12,000. (Of course, the $20,000 basis would be 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.
- 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 formal documentation showing your employer’s promise to make an in-kind distribution of the company shares.
- 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. 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.
- 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. 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 should withhold 20% of distributions from a qualified plan for taxes.
- Know Your Liabilities. You should have your tax professional prepare a tax projection to determine the amount needed, and be prepared to pay the tax man in April.
- 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 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 portion 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.
- 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.