How to Use and Take Advantage of Net Unrealized Appreciation
Do you have company stock through a plan with your employer? If so, don’t miss out on a possible tax planning strategy utilizing a net unrealized appreciation (NUA) strategy. NUA is often misunderstood and/or overlooked. Here are some things you should know about NUA, and how it can benefit you when it comes to taxes.
Net Unrealized Appreciation
Net unrealized appreciation is the gain in employer stock shares that are held in a tax-deferred account such as a 401k. An NUA strategy allows gains that happen inside the plan to be taxed outside of the plan at lower long-term capital gains rates.
For example: imagine you own 500 shares of your company’s stock in your 401k and the initial price was $10. The total cost basis is $5,000 (500 x $10). Some years later, it is now time for retirement and the stock is worth $25. Your cost basis is $5,000 (what you initially paid), while your NUA is $7,500 ($25 X 500 Shares -$5,000 Cost). Normally this would be distributed out of the plan and you would owe ordinary income tax on the entire $12,500 value of the shares at distribution.
By utilizing NUA you can pay taxes on the gain portion of the distribution at the long-term capital gains rate instead of the ordinary income tax rates, which tend to be higher.
How to Utilize a NUA
In order to use NUA, there are a few requirements that you must adhere to. The first is you must go through a triggering event. Triggering events include reaching retirement age, termination of the plan, and the most common event is separating from service. Once you separate from service you need to make a calculation to determine if NUA treatment will be the best choice for you. This would depend on your anticipated future tax rates, future Required Minimum Distributions from tax-deferred accounts, Social Security Benefits, Pension earnings etc.
Next you must make a lump sum distribution. This means the entire account balance MUST be distributed in one tax year. This is not just the stock with the gain amount but rather the entire account whether it is employer stock or other investments. A plan participant leaving an employer typically has four options (and may engage in a combination of these options), each choice offering advantages and disadvantages. When appropriate for the client, we assist clients in moving the employer stock to a taxable account while the remainder would rollover to an IRA that would continue to potentially benefit from tax deferral, leave the money in your former employer’s plan, if permitted, roll over the assets to your new employer’s plan, if one is available and rollovers are permitted, or cash out the account value.
The last requirement is that the stock must be distributed in-kind. The shares must leave the plan and go into a taxable account. You can not sell the shares in the plan and then move out of the plan. The actual shares must leave the account. ONLY actual shares are eligible for NUA treatment. Stock options, restricted stock units and phantom stock are not eligible for NUA treatment. The code does make an exception for employer stock funds as long as they can be converted to actual stock first and then transferred out of the account.
It is important to follow all of these steps to ensure that your distribution qualifies for the beneficial tax treatment.
Sarah is separating from service. She has a 401(k) valued at $500,000. Of that $500,000, $90,000 is employer stock which was purchased for $20,000. That $90,000 of employer stock can be transferred to a taxable account while the remainder is rolled over to an IRA. The cost basis of $20,000 will be taxed at the ordinary income tax rate while the other $70,000 is her NUA amount and will be taxed at the long term capital gains tax rate.
When NUA may be Advantageous.
Once you experience a triggering event, here are some things to consider when deciding to rollover your stock to an IRA or a taxable account.
- Current Tax Rates: If your income tax rate is higher than the capital gains tax rate, then NUA may benefit you. The greater the difference, the more advantageous it is.
- Appreciation: The higher the appreciation of the stock, the higher the dollar amount for a NUA. The more appreciation, the higher amount that can qualify for the lower capital gains rate.
- Low Basis Stock: Look for shares that have the lowest basis as you can pick which shares you want to get NUA treatment and which to roll to the IRA. You do not have to use ALL of the employer stock but can cherry pick which share lots you want to use.
The NUA strategy can be complicated and we suggest you reach out to an advisor and tax planner to figure out if this often-overlooked strategy would be beneficial to you.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
Walsh & Associates and LPL Financial do not provide tax advice.
There is no assurance that the techniques and strategies discussed are suitable for all investors or will yield positive outcomes. The purchase of certain securities may be required to effect some of the strategies. Investing involves risks including possible loss of principal.