If you own shares of your company’s stock within your employer-sponsored retirement plan (e.g. 401(k), profit-sharing plan, etc.), you will have several options available to you when you retire or are eligible to take a distribution from your plan. If you find yourself in a position where your company’s stock has appreciated significantly, you may want to consider utilizing the net unrealized appreciation (NUA) tax strategy. This strategy will provide an employee with the ability to maintain their company’s stock position while also providing the potential for tax savings. Before we review the mechanics of the NUA strategy, let’s first cover the rules and regulations surrounding the strategy.
In order for an employee to be eligible for the NUA strategy he/she must own actual shares of their company’s stock within their employer-sponsored plan, and satisfy one of the following conditions:
- Attainment of age 59 ½
- Separation of service/retirement
- Permanent disability (for self-employed individuals only)
At this point you may be asking yourself “What is the NUA and how could the strategy be beneficial to me?“ In simple terms, the NUA is the difference between the price the employee initially paid for company stock (its cost basis) and its current fair market value. I think the best way to explain the NUA is through an example:
- Ten years ago an employee purchased 500 shares of company stock within their employer plan for $20 per share (resulting in a cost basis of $50,000.) Over the last ten years, the stock price increased significantly, and it is now worth $300 per share, and now the overall value of the stock position is worth $150,000. The NUA in this example is the difference between the current value ($150,000) and the cost basis ($50,000), or $100,000.
Now that we know how to calculate the net unrealized appreciation, let’s discuss how the strategy works and why it can have the ability to provide an employee with some tax savings. If the employee experienced one of the events listed above, then they will need to decide about what they do with their employer-sponsored retirement plan: do they roll over the balance to an IRA or leave it where it is? Regardless of which option they choose, when they begin taking distributions from either their IRA or employer plan, those distributions will be taxed as ordinary income in the year distributed. If the employee is under the age of 59 ½ at the time of distribution, then the IRS will also apply a 10% penalty on the distribution.
However, if the employee elects the NUA strategy with the shares of company stock, they will be able to convert the taxation of the NUA ($100,000 in our example) from ordinary income into a long-term capital gain. The benefit of turning ordinary income into a long-term capital gain is the preferential tax treatment awarded to long-term capital gains. Long-term capital gains are taxed at either 0%, 15%, or 20% (depending on your income tax bracket). However, the employee must be aware that they will not be able to completely escape ordinary income tax with the NUA strategy. This is because the IRS will include the cost basis of the shares ($50,000) in the employee’s income for the year.
- Continuing our example from above, the employee decided to retire earlier this year when he/she was 62 years old. Let’s also assume that he/she will be in the 24% tax bracket over the course of their retirement. If they elected to perform the NUA strategy, then only $50,000 will be taxed at 24% this year while the NUA of $100,000 will be taxed at 15% when he/she chooses to sell all or a portion of the shares.
As far as mechanics, it is important to note that the employee must distribute the entire balance of their employer-sponsored plan within one tax year (although he/she doesn’t have to take all the distributions at the same time). In addition, in order to take advantage of the NUA strategy, the shares of company stock must be distributed “in-kind” to a taxable brokerage account. Once there, the employee can choose to either hold onto the shares or sell them to diversify their holdings.
If you are considering implementing the net unrealized appreciation strategy it is important to work out the various tax scenarios and incorporate them into your financial plan so that you can determine the best option given your financial situation. Therefore, I would suggest that you work closely with your financial advisor and/or tax professional to ensure that the strategy is implemented correctly.