Net Unrealized Appreciation: A Great Company Stock Strategy- Article featured on Money
By: Brian Bowen
Employers are increasingly using company stock as part of an incentive plan or as the delivery vehicle for the company’s 401(k) match. While employees see potential gains in their 401(k) accounts because of rising stock prices, their portfolio allocations could become unbalanced over time. When they retire or leave the company, the natural reaction is to sell some of that stock. The manner in which they do that can be critical; they may be missing out on a little known, but potentially lucrative, tax rule regarding Net Unrealized Appreciation.
A One-Time Opportunity
The opportunity to employ this strategy is available upon a triggering event like retirement, separation, age 59-1/2, death, or disability of a business owner. Instead of rolling over the entire account into an IRA, the owner takes a lump sum distribution from the 401(k) plan. The employer stock is deposited in a taxable brokerage account in the employee’s name, and the other assets are rolled over to an IRA to continue deferring taxes on the non-company stock. In addition to tax savings, this increases flexibility and lessens the burden of future RMD’s by moving some holdings from tax-deferred to after-tax status.
When you take a distribution of company stock, the basis price of the stock is taxed at your ordinary income rate. What happens next is the important part: normally, stock must be held for at least one year to be eligible for the lower capital gains tax rate. Under Net Unrealized Appreciation rules, any gain on the sale of that stock can qualify for the capital gains rate in effect at the time of the sale, even if sold the day after it was deposited in the brokerage account. If there is substantial gain, that could translate to significant tax savings.
Here is a hypothetical example to help illustrate. Roger retires with a plan that includes $300,000 of company stock with a basis of $50,000. Upon distribution, he is responsible for taxes of $14,000 ($50,000 basis times his 28% federal tax rate). If he sells the shares the next day, the appreciation of $250,000 will be taxed at a 15% capital gains rate equaling $37,500. The total taxes on the two transactions is $51,500. If he instead rolls the shares into his IRA and then takes a subsequent distribution, the ordinary income rate of 28% applies to the full share value, incurring $84,000 in federal taxes. By employing the NUA strategy, Roger could potentially save $32,500!
What if I Don’t Want to Sell Right Away?
If you decide to hold some or all of the stock after it is transferred, the capital gains rate will apply to the gain ($250,000 in the above example). Any further appreciation will be taxed as ordinary income unless you hold the stock for more than one year. Future dividends are taxable at your ordinary income rate. If you anticipate the stock will continue to appreciate, the tax savings also increase.
For inherited NUA stock, heirs inherit your cost basis in the stock, and they are entitled to the same treatment you would have received (i.e. pay no ordinary income tax on the NUA), but they must also abide by the same rules. If there is any appreciation between the date you distributed the stock from the 401(k) and the date you die, the value of the appreciation will receive a step-up in basis. For tax purposes, your beneficiaries can receive the stock at the value it was on your date of death. If they sell it for the same price as when they inherited it, there is zero tax to them—it could pass to them tax-free.
Know the Rules
To qualify for the tax break, you cannot take any withdrawals (or sell the stock) from the retirement plan before taking a distribution of the stock, including required minimum distributions after age 70½. If you do, you are ineligible for the tax break.
It is important to consider the 10% early distribution penalty that applies to the cost of the stock for distributions from tax-advantaged plans. If the employee is at least age 55 and takes the distribution after separating from the employer, the 10% penalty usually does not apply. Even so, if the stock has appreciated enough (the NUA is worth more than the original amount), it could still be worthwhile to pay the penalty in order to capture the NUA benefit.
The NUA tax break strictly applies to shares in the company you actually work for. You should only consider taking advantage of it if the stock has appreciated significantly from the time it was purchased by your plan. If it has not, you could be better off rolling it over to your IRA and letting it continue to grow tax-deferred.
Consider timing to combine this with other tax strategies for a one-two punch. A skilled tax planner can help you see the whole picture and determine the scenario that best fits your situation.
Read Brian’s article, “Net Unrealized Appreciation: A Great Company Stock Strategy” on Money Magazine’s website.