Key Points

• Net Unrealized Appreciation (NUA) is the difference between the market value of employer stock and the amount originally paid for that employer stock held in a retirement plan.

• Upon distribution from a retirement plan, provided that certain conditions are met, the IRS may allow for a more preferential tax treatment of the employer stock investment that includes NUA. 

• Before proceeding with any related planning, you’ll want to seek a careful evaluation of the tax and overall financial planning related to an investment containing NUA.

There are many benefits that employers offer employees to incentivize them or make them feel more committed to the company. One of those benefits is through owning company stock. When this stock ownership is held in a tax-deferred retirement account, such as a 401(k), possible Net Unrealized Appreciation (NUA) should be evaluated.

What is Net Unrealized Appreciation?

NUA is the difference between what you originally paid for that stock in your plan (your cost basis) and the fair market value of that stock.

How Does Net Unrealized Appreciation Affect Taxes?

While receiving income tax deferral in a retirement account, retirement accounts accumulated on a pre-tax basis are normally subject to ordinary income tax rates upon distribution. Investments within those same tax-deferred plans that contain NUA, on the other hand, could potentially be taxed on the typically lower capital gains tax rates.

In order to evaluate this possible benefit, we’ll want to look at several considerations and requirements such as:

1. Eligibility

2. Timing

3. Personal situation

Eligibility

Account holders must meet certain criteria to be eligible for this unique tax treatment. First, only 401(k) Plans can benefit. Roth accounts, for example, would not be eligible, nor would employer stock held in a taxable brokerage account.

Other qualifications include a “triggering event,” such as reaching age 59.5, a separation from service, death, or disability. These triggering events would allow for a distribution from the employee’s retirement plan. Individuals younger than full retirement age may become eligible for disbursement; however, retirement plan balances distributed for NUA planning or otherwise may still be subject to early withdrawal penalties.

Timing and Taxation

In most cases, distributions from retirement plans are in the form of cash and subject to ordinary income tax rates. For a qualified distribution dealing with NUA, however, only the original cost basis of the distribution is subject to tax rather than the fair market value. In the distribution year, the cost basis of the shares distributed will be taxable at ordinary income tax rates.

Upon the sale of those shares after the distribution from the 401(k) Plan, the gain from NUA is subject to long-term capital gains taxation. If the NUA-shares are instead held beyond distribution date from the 401(k) Plan, capital gains tax exposure will continue to be a factor for any additional appreciation that occurs subsequent to the NUA distribution.

It’s important to also note that appreciation after the distribution date would be exposed to short-term or long-term capital gains rates, depending on the holding period.

Once the position holding NUA has been distributed, the account holder must also ensure that the entire remaining balance of the retirement plan is distributed within the year. If not completed, the transaction’s integrity could be in jeopardy and the NUA tax treatment denied. This distribution of the remaining balance does not have to be in a taxable distribution but could involve a rollover of the remaining balance of the qualified account into an IRA or another 401(k) Plan.

It’s also important to note that the NUA shares must be transferred out ‘in kind’. Sales of the stock, distribution and subsequent repurchase outside of the account holding the initial investment will not qualify.

Additional Planning Considerations

While on its face, the tax benefit of the NUA planning seems clear, there are many issues and possible disadvantages to this strategy.

Investors utilizing NUA planning should recognize that although they’re benefiting from seemingly preferential tax rates, they are deciding to incur taxation that could otherwise continue to be deferred until a later date. Investors should ensure that the benefits of recognizing that tax sooner than necessary does not place them in an inferior position then would occur by otherwise delaying the distribution.

Stock basis is also an important consideration. The lower the cost basis, the less tax that’s required to be paid on distribution. The higher the cost basis, the higher the overall blended tax rate will be on the ultimate sale of that stock. That higher tax paid results in a current “hit” to your overall investment dollars, reducing the principal available for further growth.

On the other hand,  the more favorable capital gains tax on highly appreciated employer stock can be beneficial. Over time, it can also reduce the total balance in your tax-deferred accounts, resulting in lowering the required minimum distributions when reaching age 72.

While the NUA distribution planning presents the potential for added value and tax savings, all factors should be looked at comprehensively and evaluated before proceeding with the related planning and distribution.

Capstone Financial Advisors know that managing, growing, and protecting your wealth shouldn’t be complicated. Contact us to answer any questions you have. Let us help you today.

Disclosures:

This article is not a substitute for personalized advice from Capstone and nothing contained in this presentation is intended to constitute legal, tax, accounting, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. This article is current only as of the date on which it was sent. The statements and opinions expressed are, however, subject to change without notice based on market and other conditions and may differ from opinions expressed by other businesses and activities of Capstone. Descriptions of Capstone’s process and strategies are based on general practice, and we may make exceptions in specific cases. A copy of our current written disclosure statement discussing our advisory services and fees is available for your review upon request.