If you work at a publicly-traded company, you may be given employer stock or the opportunity to purchase employer stock in your retirement plan, most commonly in an ESOP or 401k plan. Typically, the funds in your retirement account grow tax-deferred, and when you take a distribution the funds are taxed as ordinary income.
In the case of an individual with a retirement account that contains employer securities, the IRS has allowed for what’s called Net Unrealized Appreciation, otherwise known as NUA. This special tax treatment allows you to take advantage of long-term capital gains rates, which are more favorable than ordinary income tax rates.
In this article, we will look at the requirements of NUA, how it works, and the advantages and disadvantages of electing this special tax treatment.
To make the NUA election, there are several requirements that must be met:
- There must be an in-kind distribution, which means you must directly transfer the employer stock to a taxable investment account. If you sell the shares within your 401k and then roll over the proceeds to an IRA, you lose your ability to take advantage of NUA.
- You must take a lump-sum distribution, which means you must distribute the entire account balance in the year you take an NUA distribution. This means that in addition to transferring out the employer stock in-kind, the remaining balance must either be distributed as a taxable withdrawal or rolled over as well.
- To qualify for NUA treatment, the in-kind, lump-sum distribution must be made on account of death, disability, separation of service, or reaching the age of 59½. If your qualifying event is separation from service, you may be subject to an early withdrawal penalty prior to age 59½. If you separate from your company at age 55 or later, you may make a penalty-free distribution from that employer’s 401k prior to age 59½. Note that any past employer 401ks are not eligible for the same penalty waiver.
Like we mentioned earlier, funds in a retirement plan are typically taxed at ordinary income rates when distributed. When an NUA distribution occurs, the cost basis of the employer securities is taxed as ordinary income at distribution. The appreciation (the difference between the cost basis and fair market value at distribution) is taxed at more favorable long-term capital gains rates.
While the ordinary income tax on the cost basis occurs at distribution, the long-term capital gains tax on the appreciation doesn’t occur until the employer stock is sold. If you end up holding the employer stock beyond the date of distribution, the additional appreciation will be taxed at either short-term or long-term capital gains rates depending on the holding period, which starts at the date of distribution.
Should You Use the NUA Strategy?
It is important to note that NUA is a choice, not a requirement. It may be beneficial for some and not beneficial for others, depending on their specific situation. The upside is that you can take advantage of long-term capital gains rates on a portion of your retirement plan, instead of ordinary income rates. The downside is that you are paying a large amount of tax sooner, rather than spread out over time. It is also important to consider how much your cost basis of employer stock is; if it’s a very high cost basis and/or there isn’t a significant amount of appreciation, it may not be beneficial to utilize NUA.
So determining whether or not the NUA strategy is right for you depends on several factors that you will want to take into consideration.
For example, if most of your retirement savings are in tax-deferred accounts, the NUA tax treatment offers an opportunity to potentially create more balance in your pre-tax versus post-tax assets, and therefore potentially lowering your required minimum distributions (RMDs) in retirement. And if you are nearing retirement, NUA is more beneficial. However, if you are younger, there is more time for your assets to grow on a tax-deferred basis in your IRA. This means NUA will be of less benefit to you because those growth years are likely to outweigh any lower capital gains tax rates. You’ll also want to consider your current and future tax rates, the actual amount of the NUA, and the risk involved.
If you have any questions about how NUA could be beneficial to you, please feel free to reach out to us!
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.