As part of their compensation package, some employees receive stock in the company or have the option to enroll in the company’s employer-sponsored retirement plan, which may include employer stock. Net unrealized appreciation (NUA) is a special provision allowed by the IRS that relates to an appreciated employer stock in a retirement plan, such as a 401(k).
This provision allows plan participants to receive a full lump sum distribution from their employer-sponsored plan and request that the appreciated employer stock be moved to a brokerage account.
How Net Unrealized Appreciation is Taxed
Typically, distributions from a tax-deferred account are taxed at the ordinary income rate, and this is where NUA can potentially result in tax savings for the investor. The amount at which the investor originally purchased the stock, known as cost basis, will be treated as ordinary income upon distribution of the stock.
However, the appreciation amount of that stock will be taxed at a future date once the stock is sold. When this occurs, the gain in the stock will be treated as long-term capital gains rather than ordinary income. See below for an example from the Corporate Finance Institute for how using the NUA strategy may be worth considering when compared to an ordinary income tax distribution.
Net Unrealized Appreciation Tax Treatment Requirements
There are three requirements for appreciated employer stock to be given NUA tax treatment:
- Stock must be distributed in-kind.
- Shares must be transferred directly to a taxable investment account, not repurchased outside of the account, or sold for cash.
- The employer retirement plan must make a lump sum distribution.
- Net unrealized appreciation needs to be taken all at once. The entire balance must be transferred within a single tax year.
- A triggering event must occur.
- A “triggering event” is characterized by death, disability, retirement, other severance from employment (termination or quitting), or reaching retirement age.
Questions to Consider with an NUA Tax Strategy
Keep in mind that the long-term capital gains rate is usually lower than the ordinary income tax rate and could make the most sense to consider the closer you are to retirement. Depending on your retirement and tax planning goals, there are other questions you may want to discuss when using this strategy, such as:
- Does the employer stock have a high or low basis? Low-basis employer stock is preferable in an NUA transaction.
- Would you want to maintain the funds inside of a tax-deferred retirement account where buys/sells do not trigger additional income taxes?
- How might the income from NUA affect other tax strategies?
Net Unrealized Appreciation Planning with Chatterton & Associates
Net unrealized appreciation is a nuanced strategy for tax and retirement planning. To avoid costly mistakes and take advantage of potential tax savings, it’s best to consider this strategy with experienced financial and tax professionals. Contact Chatterton & Associates to determine whether using an NUA tax treatment is right for your financial needs.
The Team at Chatterton & Associates