Net Unrealized Appreciation (NUA)
What is Net Unrealized Appreciation?
Many employers offer their employees the opportunity to purchase shares of stock in the company. The reason many companies offer this option is that it aligns the interests of employees with the interests of the employer, in that employees will potentially take action to improve profitability of the company which in turn should cause the stock price to rise. The company becomes more successful, and the value of the employee’s stock increases.
When an employee leaves the company or reaches the minimum age for retirement distributions, a decision needs to be made as far as what steps to take with the retirement assets that were invested with the employer. Many individuals will choose to roll over their employer 401(k) to an IRA, but there is another option that should be evaluated and considered.
Net Unrealized Appreciation is the difference between the current fair market value of the shares of stock in the employer company, and the average cost basis of the shares based on when they were originally purchased or provided. Typically, when an individual transfers pre-tax 401(k) assets to an IRA, those funds will all be taxed under ordinary income tax rates when the individual eventually takes distributions. Existing tax law, however, allows an individual to elect to take distribution of appreciated employer stock and pay capital gains tax rates on the appreciation instead of ordinary income tax rates. Ordinary income tax rates generally are higher than capital gain tax rates, so in certain cases an individual can save a substantial sum in tax liability by electing for a NUA. Whether a NUA should be considered depends strongly on the individual’s specific circumstances.
When does an NUA make sense?
First and foremost, there are several general requirements to qualify to complete an NUA. A lump sum distribution must be taken from the retirement plan within one year of the qualifying event taking place, and the distribution must include 100% of the assets included in the account held with the employer. Qualifying events include voluntary or involuntary termination from the employer, reaching the minimum age for a distribution, becoming disabled, or becoming deceased. All stock distributions are required to take place as shares of stock and cannot be converted to cash prior to the transfer.
Whether electing for a NUA makes sense generally depends on how much appreciation occurred with the company stock, the individual’s ordinary income tax rate today, and the individual’s expected future ordinary income tax rate when he would otherwise plan to take distribution of the assets. If an NUA is used, the basis of the company stock is taxed under ordinary income tax rates while the appreciated portion of the stock is taxed at the more favorable capital gains tax rates.
For this reason, generally an NUA has greater benefits when a high level of appreciation has occurred with the shares. If a small amount of appreciation has taken place, an individual is in a higher ordinary income tax bracket, and the individual expects to be in a lower ordinary income tax bracket in retirement, then the better option may be to defer the tax liability as opposed to electing to complete an NUA transaction. Let’s discuss an example where an NUA transaction would be beneficial:
John has an employer 401(k) account with a balance of $200k, and $25k of this amount is invested in his employer’s stock. His average cost basis for his employer stock is $10k, as the company has experienced substantial profitable growth which led to a significant rise in the value of the shares. John is married with a combined annual income of $60,000, and he expects to have a higher income level in retirement which will put him in a higher ordinary income tax bracket. By electing for an NUA transaction, John will pay ordinary income tax rates on his $10,000 basis in the investment, and his gain of $15,000 will be taxed under the long-term capital gains tax rate of 0%. By electing for an NUA, John received the $15,000 gain tax-free and only had to pay the ordinary income tax rate on the $10,000 basis value. As a result, he received a distribution of $25,000 and paid a 12% federal income tax rate which equates to $1,200, or 4.8% of the total distribution. Even after including FICA and state taxes, John saved a sizeable sum in taxes as a result of electing to complete the NUA.
Alternatively, the NUA process may not be best for an individual who did not experience a substantial level of appreciation with their company stock who is also in a higher tax bracket:
Steve has accepted a promotion with another firm and is deciding whether to complete a rollover of his entire company 401(k) assets to a traditional IRA, or to elect for an NUA transaction on the company stock portion of his balance. Steve has $20,000 in company stock which has an average cost basis of $18,000. Steve is married and earns $350,000 per year, which puts him in the 32% federal income tax bracket. He has 5 years until retirement, and he expects to average $200,000 per year in distributions during retirement which will put him in the lower 24% federal income tax bracket. By electing for an NUA transaction, Steve would pay his current ordinary income tax rate of 32% on the $18,000 basis position, and the capital gains tax rate of 15% on the $2,000 appreciation portion. This amounts to $6,060 in total in taxes paid today. Alternatively, if Steve transfers his employer stock position to a tax deferred IRA and instead takes the distribution during retirement 5 years from now, he will pay an ordinary income tax rate of 24% on the entire balance. This equates to $4,800 in taxes owed in addition to the benefit associated with deferring the tax bill and allowing for additional appreciation of his investment.
Summary
A tax strategy known as Net Unrealized Appreciation (NUA) can be an effective way to reduce tax liability. This strategy allows an individual to pay the lower capital gains tax rates on a portion of tax-deferred assets as opposed to paying the higher ordinary income tax rate at a later date. It is important to evaluate the tax implications based on the individual’s specific circumstances to determine whether an NUA transaction is appropriate and beneficial.