Taking Every Advantage of Available Tax Benefits
Let’s not get hung up on the hyper-technical name of this tax strategy: “Net Unrealized Appreciation” (NUA), but rather unleash its potential in more reasonable terms! Employers often include their company stock as an investment choice within the company qualified plan (e.g., 401(k), ESOP). If you elected to hold company stock in your qualified plan, and it has increased in value considerably (think 5x), this technique should be carefully evaluated.
How the Strategy Works
There is a rule within the federal tax code1 that, when properly executed, allows plan participants to request an “in-kind” distribution of company stock from their qualified plan to a non-qualified account (e.g., individual, joint or revocable trust). Upon doing so, the cost basis (i.e., amount paid for the stock) is subject to ordinary income taxes in the current year while the unrealized gain is not subject to taxation until the shares are sold. Upon sale of the company stock, the unrealized gain that occurred in the qualified plan receives long-term capital gains tax treatment. Simply put, this strategy has the potential to recharacterize the applicable tax rates from higher ordinary rates to lower capital gains rates.
When It Is Most Attractive
While there are a number of considerations to determine if this strategy is appropriate, one factor must be present: a low-cost basis relative to the market value of the stock. Generally speaking, the larger the spread between the cost basis and the market value of the stock, the more attractive it becomes. This strategy is also particularly helpful for individuals with minimal tax diversification (i.e., most of their assets are tax-deferred), and/or if they anticipate future required minimum distributions in excess of their needs. Careful consideration should be given in the context of your financial plan.
- There must be a triggering event (note: each triggering event creates a new opportunity)
- Separation from service
- Attainment of age 59 ½
- Death or disability
- In the year of execution, 100% of the remaining assets (e.g., non-employer stock) in the qualified plan must be distributed by December 31st. The remaining assets can be rolled over to an IRA, a non-taxable event.
- Employer stock must be distributed “in-kind.” The plan administrator should NOT sell the employer stock. You should request the shares be transferred to a non-IRA account.
Triggering Event Illustration: Meet Emma
Emma retired at age 56 in 2020. Her separation from service is a triggering event, thereby creating an opportunity to utilize NUA. She decided to take a $10,000 distribution from her 401(k) in 2020. In 2021, Emma learns of the NUA strategy. Is she eligible to execute NUA? She is not. Her triggering event was at her retirement in 2020, and she took her first distribution of $10,000 in the same year. Since she did not do a lump sum distribution in that year, she is not eligible for NUA. In this example, Emma would be eligible to execute NUA upon reaching age 59 ½ because the attainment of age 59 ½ is a new triggering event.
A 10% early withdrawal penalty is incurred on the cost basis if the individual is under age 59 ½ but who otherwise qualifies. This penalty does not apply if a separation of service occurred after the age of 55.
Not all plan administrators account for cost basis the same way. Some utilize only an “average cost per share,” while others track the cost of each specific lot making it possible for you to request this strategy apply to only the lowest basis shares. This strategy can be applied to only part of your company stock holdings; it is not all or nothing.
Consideration of the 3.8% Net Investment Income Tax (NIIT) should also be incorporated into the analysis. Should your qualified plan contain after-tax contributions, additional options may be available. It may be beneficial to utilize the after-tax contributions to offset the ordinary income tax portion of the distribution (e.g., the cost basis).
Another major consideration is what do to with the company stock post-distribution. If the company stock represents a significant portion of your overall net worth, and a decline in the company stock price would have material adverse consequences to achieving, or maintaining, financial independence, then there are number of risk mitigation techniques that Creative Planning can implement.*
Executing Net Unrealized Appreciation is a complex strategy, and you may want a professional to guide you through it. At Creative Planning, we help our clients develop custom strategies to achieve their long-term goals. If you would like to learn more about whether NUA is appropriate for your personal financial situation, Creative Planning is here to help. Contact us to learn more.
- Internal Revenue Code 402(e)(4)
*For more on this topic, we recommend these articles written by our colleagues:
Diet Tips for an Overweight Company Stock Portfolio – Bob Harris