Many companies offer their employees the opportunity to own their employer’s stock in a tax-deferred employer-sponsored retirement plan. The idea is that these plans create an ownership mentality in the employees, even if it’s just a small percentage of total shares. Net unrealized appreciation (NUA) is a strategy that can be employed when distributing this employer stock from your retirement account, but it’s important to understand the requirements and how it works to effectively take advantage of this benefit.
The first aspect to understand is that when you take a distribution from a tax-deferred employer-sponsored plan, you are paying the ordinary income taxes you’ve been deferring on the amount distributed. Using the NUA strategy, you can instead pay the advantageous capital gains tax rates on a portion of your distribution rather than ordinary income taxes, which are higher.
The NUA portion of your retirement plan is the difference in value between the cost basis of the company stock and its market value at the time it is distributed. So, if you own 10 shares of stock that you paid $10 per share for, your cost basis is $100. If by the time you are taking the distribution those shares have appreciated and are trading at $30 per share, your net unrealized appreciation (NUA) is $200 – you paid $100 for them, but they’re worth $300 now.
When utilizing the NUA strategy, you must take a lump-sum distribution of all the assets in your employer-sponsored retirement plan account. The employer stock is distributed in-kind (meaning you don’t sell it) and usually moved to a brokerage account. The rest of the assets can be rolled over to another retirement account so that the entire distribution isn’t taxed as ordinary income. If this is done correctly, then you pay ordinary income tax on the cost basis of the shares of employer stock (the $100 mentioned in the example above) and you can defer taxes on the NUA (the $200 gain mentioned in the example above) until you decide to sell that stock in your brokerage account. Regardless of how soon you sell the stock after you receive it in-kind, the NUA is taxable as a long-term capital gain. Any additional gain is taxed based on the holding period of the shares after they are distributed. So, circling back to the example above: in a typical scenario you would pay ordinary income taxes on the entire $300 value of the shares whereas in the NUA strategy, you’re paying ordinary income taxes on the $100 cost basis and lower capital gains taxes on the $200 gain. Using this strategy, you owe less in taxes on the same distribution amount.
To utilize this strategy, you must be eligible to take a lump-sum distribution from your plan. According to typical plan rules, this would be due to separation from employment, death, disability, or being 59 ½ years of age. The company stock must also be distributed directly from your workplace plan – you can’t roll it to an IRA, then distribute it; this would disqualify you from NUA treatment. It’s also important to consider if you can afford to pay the income tax on the cost basis of the stock you distributed in the year it was distributed.
This strategy may be appealing even to those who separate from service prior to age 59 ½, even if the 10% early withdrawal penalty applies. For instance, a 50-year-old who separates from service can still do an NUA distribution. The cost basis of the shares will be subject to ordinary income taxes, plus the 10% early withdrawal penalty. However, if the cost basis is low enough, the penalty may be so small that the NUA strategy is still worthwhile for the overall tax savings.
This can be a beneficial strategy for anyone in a high-income tax bracket owning employer stock in a workplace plan. If you own employer stock in your retirement plan and are wondering if this strategy makes sense for you, we would be happy to discuss your specific situation and help you identify if NUA fits into your financial plans.
Presented by Elizabeth Schleifer, CFP®