Employer-issued stock in qualified retirement plans can provide a planning opportunity called Net Unrealized Appreciation (NUA).
In this article, we’ll explain the basics of NUA, how it works, its potential benefits, and key considerations. We recommend consulting your tax and financial advisor prior before executing this strategy.
What is Net Unrealized Appreciation (NUA)?
NUA is the difference between the original cost basis of employer stock in a retirement plan and its current market value. For example, if you purchased company stock at $20 per share and it’s now worth $50 per share, the NUA is $30 per share. This $30 appreciation can qualify for preferential tax treatment when properly managed.
How does NUA work?
When you hold employer stock in a qualified retirement plan like a 401(k), you have the option to distribute that stock "in-kind" as part of a qualifying event such as retirement, job termination, or reaching age 59½. An "in-kind" distribution means the stock is transferred to a taxable brokerage account without converting it into cash. This process triggers unique tax treatment under the NUA rules:
- Immediate Taxation on Cost Basis
The cost basis, or the original amount you originally paid for the stock, is taxed as ordinary income upon distribution. - Capital Gains Tax on NUA
The NUA portion is not taxed immediately. Instead, it is deferred until you sell the stock. When you do sell, the NUA amount is taxed at the long-term capital gains rate. Long-term capital gains taxes are typically lower than ordinary income tax rates, regardless of how long you've held the stock after distribution, but you should discuss specific rates with your tax professional. - Taxation on Additional Gains Post-Distribution
If the stock appreciates further after the in-kind distribution (beyond the NUA), this additional growth is taxed when you or an heir sells the shares. The tax rate depends on how long you've held the stock post-distribution. If you hold the stock under 12 months, gains are taxed at the higher short-term capital games rate; holding the stock 12 months or more qualifies you for the long-term capital gains rate.
Advantages of an NUA strategy
Employing an NUA strategy can offer several financial benefits:
- Potential Tax Savings:
- Any difference between marginal income tax bracket and capital gain rate upon realization is saved by the taxpayer.
- Dividend paying stocks can be taxed at special long-term capital gain rate when paid (not ordinary income tax in an IRA).
- Reduced Required Minimum Distributions (RMDs):
Transferring employer stock out of a retirement account reduces future RMDs for the owner, spouse, or inherited owner. This helps prevent the “Widow(er)’s Tax Trap” for the surviving spouse. - Flexible Tax Planning:
Considering NUA allows you greater control of when to sell the stock and realize gains, allowing for strategic timing of taxable events. - Charitable and Family Gifting Benefits:
Shares gifted to family members can be sold and paid by the gift recipient at a potentially lower tax rate, or gifting shares to charity avoids taxation on NUA and can be used in combination with a qualified charitable distribution (QCD).
Key Considerations
While an NUA strategy can be advantageous, it isn’t without drawbacks and complexities. Here are some factors to consider:
- Immediate Tax Bill:
The cost basis is subject to ordinary income tax upon distribution, which could result in a significant upfront tax bill. - Rollover Requirements:
You must roll over your entire retirement account assets to an IRA and simultaneously distribute shares in-kind to a brokerage account. - Eligibility Requirements:
NUA strategies can only be used during a qualifying event, such as retirement, job termination, or reaching age 59½. - Loss of Cost Basis Step-Up:
NUA shares do not receive a step-up in cost basis at death. Instead, the heirs retain the original cost basis and NUA tax treatment. This can have significant implications for estate planning and future taxes for heirs. - Taxation Upon Sale:
When securities are sold, NUA is taxed at the long-term capital gains rate. Any additional gain is taxed based on the holding period of the securities after they are distributed. - Diversification Risks:
Concentrating too much of your portfolio in employer stock can increase risk. - Irrevocable Decision:
Rolling employer stock into an IRA forfeits NUA benefits permanently.
When does NUA make sense?
NUA is optional. Partial distributions may also be a suitable approach as opposed to an all-or-nothing strategy, allowing for greater flexibility and tailored tax planning.
NUA is most beneficial for individuals who:
- Are in a high-income tax bracket at the time of distribution but expect to pay lower capital gains tax rates later.
- Have significant appreciation in their employer stock.
- Want greater control over the timing of taxes and distributions.
- Seek to reduce future RMDs or leverage gifting strategies.
Getting started with the right team
Before implementing NUA it is important to receive tax and investment advice from a CPA and Financial Advisor. At AdviceLink® Financial Advisors, we coordinate advice with our client’s tax advisors prior to execution.