For anyone who has a qualified company retirement plan, such as a 401(k) or ESOP (Employee Stock Ownership Plan), there is a little known tax strategy that can potentially save you thousands of dollars in taxes. The strategy is called NUA or Net Unrealized Appreciation. That’s a mouthful. If you leave a company, and you are holding company stock in your company plan, you might think that rolling over that stock to an IRA is the right strategy. This may be the best for you, but you also need to consider another option; NUA.
In some cases, taking a lump sum distribution of some or all of your company stock and paying the taxes, may be the right decision. After reading that, you’re probably thinking, “Why would I pay taxes on money that could remain tax-deferred until I sell it?” If you have company stock in your qualified retirement plan and this stock is highly appreciated stock, NUA could save you thousands of dollars in taxes, when you sell the stock. In order to determine if the stock is highly appreciated, you need to look at the total cost of the stock when it was put into your company retirement plan. If the difference between the cost and the appreciated value is substantial, NUA could be a great tax benefit to you.
Before I get into how NUA works, I first want to address rolling over your company stock to an IRA. If you do this, you can sell the stock and the funds continue to be tax-deferred until you withdraw them. Once you withdraw funds from your IRA, these funds will be taxed as ordinary income. In other words, the tax on these withdrawn funds, will be based on whatever your marginal tax bracket is at the time.
This is how NUA works. If instead of rolling over your company stock to an IRA, you took a lump sum distribution of your stock and put it into a taxable account, you would only pay ordinary income tax on your original cost. You won’t pay any tax on the NUA until you sell the stock. To be clear, the difference between the value of the stock and the cost, is NUA. In other words, NUA is synonymous with appreciation of the stock. The key benefit is that you are taxed on the NUA at long term capital gains rates, regardless of how long you’ve held the stock outside of the plan, even if it has only been one day. That tax rate is typically 15%, depending on your income. NUA could significantly reduce your tax liability on your company stock if done correctly.
Some points to remember, when qualifying for NUA, the distribution must occur after a triggering event, i.e. death, reaching age 59 ½, separation from service or disability. One key to remember is that if you are under age 55 at the time of separation, you would be assessed a 10% penalty on the cost of the stock, so this strategy is best if you’re at least age 55. If you roll over your stock to an IRA, you will lose the NUA forever and any distributions from the IRA will be taxed as ordinary income.
Here’s an example of using the NUA strategy: Let’s say that you lost your job, you’re 55 years old, and you have $750,000 worth of company stock in your ESOP. After looking into the cost of the stock that the company contributed to your plan, this amount came up to $50,000. The difference or NUA is $700,000 ($750,000 - $50,000). You would pay ordinary income tax on the $50,000 and when you sell the NUA, you would pay tax at long term capital gains rates. This is a huge tax savings. Also, you can sell the stock over a number of years. In addition, now that you’ve paid tax on the $50,000, you won’t ever have to pay tax on that amount again.**
Whether or not NUA is right for you depends on many variables, and you should certainly consult with your tax advisor. This also depends on your age, your estate planning goals, your expected tax rate in retirement, and how necessary it is to diversify out of the stock, if the amount of stock constitutes too much of your net worth. As I said in the beginning, rolling over the stock to an IRA may be the best thing for you but it’s important to weigh all of your options. If you have any questions on this strategy, give us a call. We’ll walk you through the process and can provide an analysis of what’s best for you.
Daniel H. Gilbertson, CFP®, CRPC®, RFC®, AIF®
*If you are considering rolling over money from an employer-sponsored plan, such as a 401(k) or 403(b), you may have the option of leaving the money in the current employer-sponsored plan or moving it into a new employer-sponsored plan. Benefits of leaving money in an employer-sponsored plan may include access to lower-cost institutional class shares; access to investment planning tools and other educational materials; the potential for penalty-free withdrawals starting at age 55; broader protection from creditors and legal judgments; and the ability to postpone required minimum distributions beyond age 70½, under certain circumstances. If your employer-sponsored plan account holds significantly appreciated employer stock, you should carefully consider the negative tax implications of transferring the stock to an IRA against the risk of being overly concentrated in employer stock. You should also understand that Commonwealth and your financial advisor may earn commissions or advisory fees as a result of a rollover that may not otherwise be earned if you leave your plan assets in your old or a new employer-sponsored plan and that there may be account transfer, opening, and/or closing fees associated with a rollover. This list of considerations is not exhaustive. Your decision whether or not to roll over your assets from an employer-sponsored plan into an IRA should be discussed with your financial advisor and your tax professional.
**This is a hypothetical example and is for illustrative purposes only. No specific investments were used in this example. Actual results will vary. Past performance does not guarantee future results