Let’s start with a couple of questions:
- Do you have employer stock in your 401(k)?
- Is that stock highly appreciated?
If yes, do you ever wonder what happens to it when you leave?
Are you aware of special tax treatment on the stock? Read on to make sure you’re up to speed on Net Unrealized Appreciation (“NUA”), generally defined as a tax break for employees on the appreciation of company stock inside a plan.
If no, I’d skip this read as it gets a little hairy.
Let’s use this example:
Cost of shares: $200,000
Market Value: $500,000
Unrealized appreciation: $300,000 (i.e., 500K-200K).
- The cost of the shares ($200K) is reported as ordinary income in the year the NUA transaction takes place.
- The unrealized appreciation ($300K) is the amount reported in box 6 of your 1099-R, which is eligible for long-term capital gains treatment when sold (long-term capital gains rates are more favorable than ordinary income tax rates). When it is sold, it will be reported on Schedule D of your 1040.
Rules to consider:
- You must take a lump-sum distribution (in 1 calendar year)
- The distribution must occur after a triggering event (i.e., death, age 59 ½, separation of service, disability)
- NUA eligible shares must be moved in-kind to a taxable account (i.e., don’t sell them!)
- Events 1 and 2 above do not need to occur in the same year.
- Every time there is a new triggering event, a new cycle starts, offering another opportunity to do a new NUA (i.e., reach 59 ½, take partial in-service distribution but not yet retired, you still have a chance to do NUA at retirement).
Summary Thus Far:
If you pursue NUA treatment, you owe ordinary income tax on the cost of shares purchased inside the plan. The benefit is here: when you sell the shares in a taxable account, you owe long-term capital gains tax on the appreciation, not ordinary income.
You likely have other investments in the plan…
- Perform a DIRECT rollover of the investments into an IRA/tax-favored account, THEN move the stock to a taxable account, in the same calendar year, in this order.
- Why? Withholding issues. Exception: if the LAST thing in a plan is employer securities, the 20% mandatory withholding rule doesn’t apply.
- In practice, you request this at the same time. Before you submit the paperwork, ask the provider: will there be any withholding upon completion of this transaction? If they say no, then they will properly execute this order of events for you.
Future growth of employer stock in a taxable account:
- It’s now in a taxable account and continues to grow, let’s say it’s worth $1M. What happens when you sell? Reminders from our example earlier:
- NUA ($300K above) is automatically given long-term capital gains treatment (no 1 year holding period).
- You already paid tax on the cost ($200K).
- New growth above and beyond distribution (it’s grown $500K from the distribution as it is now worth $1M) follows regular capital gains rate rules (i.e., less than 1 year – short-term capital gains, more than 1 year – long-term capital gains).
- What if you pass away with NUA?
- NUA does not get a step up in basis – the beneficiary pays long-term capital gains on the NUA.
- Any appreciation after the initial distribution gets a step-up in basis.
- How to determine the costs of shares:
- This is maintained at the plan level, usually at an average share price basis.
- Have you been through a merger/acquisition?
- As long as you didn’t go to cash, you are still eligible to take advantage of NUA treatment.
- Is NUA just for public companies?
- Private companies can do this too, as long as there is no policy preventing an employee from transferring the stock to a taxable account (i.e., the company may require you to sell them back as soon as the shares are transferred, which can be an expensive tax bill incurred in one year).
Why think through this now?
- Don’t wait to do this until the end of the calendar year!
- Go back to Rule #1. Until the end of the calendar year, you have to accomplish the rollover of the other assets and in-kind transfer of the stock.
- Don’t take an RMD before doing this!
- If you do, you are not eligible for NUA (go back to Rule #1 requiring a lump-sum distribution).
- Death is another triggering event, in which case, the beneficiary can take advantage of the NUA – it’s too late for you, though.
- Do you make emotional investment decisions? Don’t sell your company stock while in the plan!
- If you sell at a loss and repurchase them, the basis is reset for your NUA transaction.
Other items to remember:
- You must let your CPA know about your NUA transaction to ensure long-term capital gains rates are applied when you sell the shares from your taxable account.
- There is no indication from the custodian on the 1099-B that those shares were part of an NUA transaction. It could be confused as a short-term capital gain, in which case those should be overridden to be classified as long-term.
- Additionally, the NUA itself is not subject to the 3.8% surtax, which applies to AGI over $200K for single filers and $250K for married filing joint. Future growth is subject to the 3.8% tax, however.
When does it NOT make sense?
- The ordinary income tax bill on your basis can push you into a new tax bracket. You might be better off by transferring the shares in-kind into a retirement account if that’s the case.
- What are you going to do with the shares once in a taxable account? You will have some tax drag on the portfolio with the stock in a taxable account (i.e., dividends).
- The greater the appreciation, the more it makes sense to pursue an NUA strategy.
- How long will you hold the shares? The older you are, the less it matters (RMDs are near).
- The goal is to aim for tax efficiency. What are the dollars going to be used for when you sell the shares? Are you purchasing a tax-efficient product (i.e., Indexed ETF vs. high-yield bond fund)?
- The ordinary income tax paid on the basis is applied today. The long-term capital gains rate is applied in the future when you sell the shares. There is no crystal ball here (i.e., your income, tax table, legislative risk, etc.).
- You can do it on a specific number of shares (and not all) if you don’t have the money to pay the income tax on the basis. It’s worth asking if your company tracks the shares at the lot level for you to pursue specific lot identification.
- Also, remember to consider cash flow needs! If you need the cash in the short-term, it could make sense, even if the appreciation is low.
Have more questions? Feel free to schedule some time together here. As a reminder, always consult your tax advisor for tax advice.