Discover how the net unrealized appreciation (NUA) tax strategy could help your clients lower their tax bill.
Despite what many would call a hostile political environment, the stock market has performed incredibly this year:
- The Dow Jones Industrial Average closed above the 24,000 mark for the first time ever on November 30, 2017.
- Between January 1, 2017 and November 24, 2017, the Dow closed at its 60th record-setting level in 2017, while the S&P 500 closed at its 55th record-setting level during the same time.
- The NASDAQ Composite closed at its 69th all-time high as of November 24, 2017.
As you read this, these numbers may well be outdated, as new all-time highs seem to be attained almost weekly. This unprecedented market performance has likely increased the value of clients’ retirement plan assets. In particular, clients with publicly traded employer stock in their retirement plan portfolios have likely experienced an increase in the stock’s value.
What Is Net Unrealized Appreciation (NUA)?
NUA is the gain on employer stock while held in a qualified retirement plan, such as a 401(k), profit sharing, stock bonus, or employee stock ownership plan (ESOP). The value of the NUA is measured by subtracting the cost basis of the stock from the current fair market value (FMV).
Internal Revenue Code (IRC) Section 402(e)(4) permits a unique tax-savings opportunity for distributions of employer stock from a retirement plan. Retirement plan distributions are subject to ordinary income tax rates up to 39.6%. However, clients who receive an in-kind distribution of employer stock from a retirement plan pay ordinary income tax only on the stock’s cost basis, not on the FMV of the stock. The growth, or NUA, that occurred while the employer stock was in the plan is taxed at lower long-term capital gains rates (presently 0%, 15%, or 20% depending upon your client’s tax bracket) when the stock is sold.
This tax break is beneficial when a stock experiences a normal rate of growth but even more so if the stock’s value has increased greatly due to the recent market performance. After all, the greater the NUA, the greater the potential tax savings realized from paying long-term capital gains rates rather than ordinary income tax rates on the stock’s appreciation. Advisors should consider this tax advantage when formulating planning strategies for clients with large concentrations of employer stock.
How the NUA Strategy Works
There are a number of steps to follow before your client can take advantage of the NUA strategy:
- Experience a triggering event:
- If your client is not self-employed, this includes reaching age 59 ½, separation from service, or death.
- If your client is self-employed, this would be reaching age 59 ½, total disability, or death.
- The entire vested balance in the plan must be distributed as a lump-sum distribution. This means that although your client does not have to take the full distribution at one time, the entire balance must leave the plan within the same tax year. If your client does not take a lump-sum distribution, only the NUA attributable to employer stock purchased with nondeductible employee contributions qualifies for favorable tax treatment.
- Other plan assets (besides the employer stock) may be directly rolled to an IRA. In addition, assets from all other qualified plans held with the employer must be distributed, even if the plans do not include employer stock, and may be directly rolled to an IRA.
- Employer stock must be distributed as actual shares and transferred to a nonqualified securities account. The value of the stock’s basis is included in your client’s income for the year of distribution. The NUA strategy is not available if your client sells the shares and then takes a distribution of the cash proceeds.
The client may sell the stock immediately after distribution from the plan or at some future date. When the client sells the stock, the NUA is taxed at long-term capital gains rates regardless of the holding period. Any further appreciation occurring after the stock’s distribution from the plan and before its sale is taxed as long-term gains (if individually held for more than one year) or short-term gains (if held less than one year).
In the event of death, your client’s beneficiaries would be able to take advantage of the NUA strategy. Please be aware the above are just the basics of NUA strategy eligibility—you must consider your client’s full tax picture before suggesting this path.
The Case of Tyler Ryan
Let us look at an example to help illustrate the NUA strategy.
Tyler Ryan retired from ABC Corp. at the age of 61. He had accumulated 1,000 shares of ABC Corp. stock in his 401(k) plan. The shares had an average basis of $10.
When Tyler fully distributed his 401(k), he elected to take advantage of an NUA strategy by moving the 1,000 ABC Corp. shares from his 401(k) to his nonqualified securities account. The remainder of his 401(k) was rolled over into an IRA. On the date Tyler distributed the ABC Corp. shares from his 401(k), the FMV of the stock was $50/share.
- The $10 of cost basis was included in his ordinary income for the year of distribution.
- The $40 of NUA on the shares at the time of distribution will be permanently treated as long-term capital gains (LTCG).
Six months after Tyler’s NUA distribution, the FMV of ABC Corp. is $70 per share, and Tyler sells 500 shares for total proceeds of $35,000.
- The initial $40 of NUA on the shares that he had at the time of the distribution is still taxed as LTCG, so $20,000 ($40 NUA x 500 shares) is subject to LTCG.
- The additional $20 in gain that accumulated after the stock was distributed from the plan was treated as short-term capital gains (STCG) because the shares were only held for 6 months after the distribution, so he had $10,000 subject to STCG ($20 STCG x 500 shares).
After another nine months (i.e., 15 months after Tyler’s original NUA election), the FMV of ABC Corp. is $75/share, and Tyler sells the remaining 500 shares for total proceeds of $37,500.
- The initial $40 of NUA on the shares he had at the time of the distribution is still taxed as LTCG, so $20,000 is subject to LTCG ($40 LTCG x 500 shares).
- The additional gain of $25 that had accumulated since Tyler distributed his NUA stock is treated as LTCG because the shares were held for more than a year after the NUA distribution, so Tyler had $12,500 subject to LTCG ($25 LTCG x 500 shares).
Over the time that Tyler held the shares, here is a breakdown of the tax consequence of implementing the NUA strategy:
- $10,000 in ordinary income tax (in the year of the NUA election).
- $10,000 in STCG (at the time the first 500 shares were sold).
- $52,500 in LTCG ($40 NUA x 500 shares from the first sale + $65 x 500 shares from the second sale).
Assuming a 25% marginal income tax rate and a 15% capital gains tax rate, Tyler would have paid the following:
- Approximately $5,000 ([$10,000 in basis + $10,000 in STCG] x 25%) in ordinary income tax.
- Approximately $7,875 ($52,500 in LTCG x 15%) in capital gains tax.
- $12,875 in total taxes.
What if Tyler had rolled these shares into an IRA instead and then sold the shares and distributed the proceeds in the same way he did above? He would have paid:
- $8,750 ([500 shares x $70 per share] x 25%) in ordinary income tax on the first sale.
- $9,375 ([500 shares x $75 per share] x 25%) in ordinary income on the second sale.
- $18,125 in total taxes.
As you can see, using the NUA strategy saved Tyler $5,250 in taxes. If Tyler had sold all 1,000 shares immediately after distribution from the plan or more than one year and one day after the plan distribution, he would have increased his tax savings by minimizing his exposure to ordinary income tax.
FINRA Notice 13-45 requires that many factors be considered before an advisor recommends a rollover of retirement plan assets to an IRA. The Notice advises that the tax benefits associated with distributing employer stock from a retirement plan and moving it to a nonqualified account rather than an IRA should be considered, as these tax benefits are lost if a client rolls the employer stock to an IRA. Once employer stock is directly rolled to an IRA, the NUA will be taxed as ordinary income (rather than capital gains) upon distribution because all IRA distributions are taxed as ordinary income. Therefore, advisors should “run the numbers” to determine whether the NUA strategy or an IRA rollover makes more sense in a client’s particular situation. Financial planning software may contain a calculator, or old-fashioned math may be used to approximate the taxes owed under each scenario. Remember that the 10% premature distribution penalty applies to clients under age 59 ½ who utilize the NUA strategy unless an exception applies; the penalty applies to the cost basis, not the NUA.
Another factor to consider from an estate planning perspective is the fact that NUA stock is not eligible for a step-up in basis at death. In addition, consideration must also be given to the risk of being excessively concentrated in that particular stock. Finally, if a client is opposed to paying any tax now, a direct rollover of the stock to an IRA to avoid current taxation may be the best option.
Recent market performance may have significantly increased the value of employer stock in clients’ retirement plans. In the right situations, the NUA strategy provides a win-win for both advisors and clients alike. After clients take a distribution from their retirement plan, advisors can manage assets in the rollover IRA and provide investment expertise and guidance for the employer stock in the nonqualified account (for instance, advice regarding when to sell it, how much to sell, how to reposition assets, etc.). More importantly, clients benefit by being subject to lower tax rates when employer stock is distributed from the retirement plan and later sold in the nonqualified account. Saving taxes through a legitimate, Internal Revenue Code-approved strategy is something clients are sure to appreciate.
About Cetera® Advisor Networks
Cetera Advisor Networks LLC is an independent broker-dealer and registered investment adviser firm that utilizes a unique regional director model to support financial advisors through the entire life cycle of their business. As part of Cetera Financial Group®, a leading network of independent retail broker-dealers, Cetera Advisor Networks is able to build and support regional teams through local service, regional offices and a national home office, facilitating the success of financial professionals.
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