If you’re ready to retire and you have highly appreciated employer stock in your employer-sponsored retirement plan, you may have a unique opportunity to reduce your tax bill.
The net unrealized appreciation (NUA) tax strategy is a one-time opportunity that can provide significant benefits, but there are complex requirements and tradeoffs. Here’s a primer to help you understand the pros and cons of this strategy. If you think the NUA strategy may be right for you, contact us and a tax professional to discuss your options.
What is NUA?
Net unrealized appreciation is the amount your employer securities — most commonly stock — have appreciated since they were purchased by the employer’s plan. It’s determined at the time of a lump-sum distribution from the employer plan by the plan sponsor or those authorized by the plan sponsor. A benefit is that any NUA amount from the appreciated securities is taxed at the long-term capital gains rate (when you sell the securities) rather than the higher ordinary income tax rate.
Who should consider the NUA tax strategy?
Employer stock with a low cost basis is a key factor. This is the value at which the employer retirement plan purchased the stock. Generally, the larger the difference in value between the cost basis and the employer stock price at the time of the lump-sum distribution from the employer plan, the more potential tax benefit with the NUA approach. You must check with your plan sponsor to verify the accuracy of your cost basis information. You will pay ordinary income taxes on the amount of the cost basis that is distributed as part of the NUA tax strategy.
NUA is also a timely consideration if you’re concerned about the potential for higher individual income tax rates in the future.
What are the requirements to qualify?
The NUA tax strategy requires a lump-sum distribution, based on a triggering event:
- Retirement or separation from service
- Reaching age 59.5
If you want to use the NUA tax strategy, you must take the lump-sum distribution from the employer plan. Your employer stock is sent directly to your non-qualified brokerage account. The remaining assets in the plan are directly rolled over into an IRA to avoid any taxation. Once the lump-sum distribution is complete you will work with your tax professional to seek NUA treatment for the employer stock.
For example, assume your employer plan purchased $100,000 of employer stock many years ago and the retirement lump-sum distribution value of the stock today is $600,000. Your basis on the stock is $100,000 and the NUA amount is $500,000. You pay taxes on the $100,000 at the time of the distribution while deferring the tax – at long-term capital gains rates -- on any NUA until you sell the shares later.
But if the value of the stock goes down before you sell it, you would pay taxes on the gain with the current price. For example, if that same employer stock with a cost basis of $100,000 decreases in value to $550,000, and you sell the stock at that price, you would pay long-term capital gains taxes on the gain of $450,000. You can sell some or all of the shares at any time that makes the most sense for your financial situation after they are in the non-qualified brokerage account.
The triggering event does not determine when you can initiate the NUA strategy. To see how that would work, view the visual example at the end of this article.
Here are additional rules and considerations:
- The lump-sum distribution of your balance from the employer plan must happen in a single taxable year. If you take distributions in earlier years, the strategy may not work. Discuss an approach with your tax professional before taking any distributions from your plan.
- At the time of the lump-sum distribution, you will incur a tax bill for the cost basis at your ordinary income tax rate. If you wait until you’re in a lower tax bracket, for example, in the year after you retire, to use the NUA strategy, it could help lessen that tax bill. You will pay taxes on the rest of the distribution unless you roll it over to an IRA. (If you do a direct rollover, you can avoid the potential 20% withholding.)
- You don’t have to distribute all of your employer securities. You can use some for NUA and rollover the rest into an IRA where they can be diversified into other investments without a tax cost.
- The entire account balance to the employee’s credit in the employer retirement plan(s) (not just the employer securities in the plan) must be distributed in that tax year. Additional money deposited in the account after the lump-sum distribution (which is not withdrawn before year-end) can impact the ability to claim NUA.
- If you continue to hold the employer stock after the lump-sum distribution from the employer plan, any appreciation beyond the NUA amount will be taxed either as a short-term capital gain (if you held the stock in your brokerage account for one year or less) or a long-term capital gain (held more than one year).
- Conversely, if the price of the employer stock drops below your cost basis in the shares — that is, the cost to the trust that was in place at the time of the lump-sum distribution from the employer plan that you paid ordinary income taxes on — you may be eligible to a receive a capital loss on your tax return.
- The NUA gain is not eligible for a step-up in basis on death.
What are additional benefits to consider?
Holding the NUA employer stock for many years (rather than selling it at the time of the lump-sum distribution from the employer plan) can potentially be more beneficial to you from a tax-deferred growth perspective. Alternatively, selling the stock immediately, or in small increments over the following years, can effectively give you a distribution from the plan that is at the lower long-term capital gains rate, rather than at the generally higher ordinary income tax rate.
The IRS allows you to select batches of employer stock for the most favorable cost basis for NUA purposes if the plan has:
- Purchased employer stock over a number of years.
- Specifically recorded the shares purchased at different prices (cost basis).
- Provided you with documentation.
Together, a tax professional and us can recommend options for a NUA tax treatment for all or a portion of the stock, depending on how your plan determined the basis of your shares.
If you have not sold the employer stock before you die and your beneficiaries meet all of the requirements, they may also use the NUA tax strategy. However, the NUA portion of the stock will not be eligible for a step-up in basis.
What are the tradeoffs with NUA?
While NUA does offer real near-term benefits, there are significant tradeoffs to consider.
- Us and tax professional can help estimate the number of years when the benefits of an IRA rollover could overtake the NUA benefits. This could factor into your decisions — for example, if your life expectancy is low or you will want access to the cash soon, NUA could be the better option.
- Continuing to hold a significant amount of employer stock may not provide proper diversification for your asset allocation strategy and may not support your financial goals, risk tolerance and time horizon.
- Employer retirement plans under ERISA generally offer bankruptcy and creditor protections. IRA assets offer some similar protections, depending on the state.
- If you sell the stock immediately after the lump-sum distribution from the employer plan, you forfeit the potential tax-deferred growth.
Lean on professionals as you consider the NUA tax strategy
Given the many implications of the NUA approach, it’s important to seek personalized advice from us and your tax professional. They know your situation and financial goals and can provide advice for specific aspects such as:
- The distribution of after-tax, non-Roth contributions
- Taxation considerations for beneficiaries
- The potential benefits of an IRA rollover of all of the plan assets instead of the NUA strategy on some, or all, of the employer stock in the plan
Here is a visual example of the NUA tax strategy.