Net Unrealized Appreciation

 


  

WHAT IS THE NET UNREALIZED APPRECIATION (NUA) STRATEGY?

This special tax treatment can help retirement plan participants who receive a lump-sum distribution that includes company stock pay taxes as low as 15% on portions of that distribution.

WHO CAN BENEFIT FROM THE NUA STRATEGY?

The NUA strategy primarily benefits individuals who own highly appreciated employer stock in their 401(k) or other employer-sponsored retirement plans. The higher your income tax bracket and the more the stock has appreciated, the more you may benefit from this strategy.

HOW DOES THE NUA STRATEGY WORK?

Assets in your employer-sponsored plan, including company stock, accumulate on a tax-deferred basis. Once you begin taking distributions from the plan, you generally must pay ordinary income tax on the current market value of the assets distributed in-kind, plus any cash distributed.

However, you can use the NUA strategy to defer paying tax or to pay the capital gains tax rate rather than the ordinary income rate on portions of your lump-sum distribution if you are eligible. Because the capital gains rate is currently 15% for most taxpayers, much lower than most ordinary income rates, the NUA strategy can significantly reduce the amount of tax you pay on your distribution.

A lump-sum distribution is a payout of your entire balance from all of your qualified plans of one kind (e.g., pension, profit-sharing, stock bonus) from a particular employer.1

With the NUA strategy:

  • You request that your retirement plan distribute the shares of your employer stock to a taxable account, at which time you pay ordinary income tax on the cost basis, also known as the average cost, of the stock. If you have mutual funds in the plan, you may have them (or their sale proceeds) distributed into a traditional IRA to maintain tax-deferred growth.
  • The cost basis is the average of the individual values of employer stock when each portion was contributed to the plan or purchased by the plan's trustee. The difference between the cost basis and the market value at the time of distribution is called the net unrealized appreciation.
  • You are not required to pay taxes on the NUA at the time of distribution, but you must pay taxes on that amount when you sell the shares.
  • At the time of sale, the NUA is taxed at the long-term capital gains rate. For highly appreciated stock, the cost basis of the securities distributed to you could be quite low, leaving you with a substantial gain that is taxed at the capital gains rate instead of the ordinary income rate.
  • If you decide not to sell the stock immediately, the share price may change between the time you take the distribution and the time you sell the shares. If the price increases, that additional appreciation is taxed either as a long-term or a short-term capital gain, depending on how long you hold the shares after distribution.

WHAT OTHER ISSUES SHOULD YOU CONSIDER?

  • In the past, the NUA strategy was not always advantageous if you did not sell the employer stock immediately after distribution because the stock dividends were taxed annually at ordinary income rates.
  • Under federal tax law, dividends received before 2011 will be taxed at 15% for most taxpayers, which is much less than most ordinary income rates. So it may be a good idea to use the NUA strategy and pay taxes on the dividends each year, as opposed to keeping the stock in your employer-sponsored plan and paying taxes at ordinary income rates when you eventually begin taking distributions.
  • If you decide to place your company stock in a taxable account:

— You lose the ability to diversify out of the company stock without paying capital gains taxes.

— Assets outside a qualified employer plan or individual retirement account (IRA) may have less protection from creditors' claims.

  • The stock price could decline or tax rates could change, defeating the tax-saving benefits of the NUA strategy.
  • The NUA strategy is less beneficial if your tax rate is likely to decline in retirement.
  • State income taxes also should be considered.

WHAT IMPACT DOES THE NUA STRATEGY HAVE ON YOUR BENEFICIARIES?

The NUA strategy can benefit your beneficiaries if you hold the stock in a taxable account and it appreciates before your death. When your beneficiaries sell the stock they inherit, they will owe long-term capital gains tax on the unrealized appreciation, just as you would if you sold the shares yourself. However, any additional appreciation between the date of distribution and the date of your death is never taxed. That amount is treated as a step-up in cost basis for your beneficiaries.