Employer stock held within an employer retirement plan is eligible for favorable tax treatment on the “Net Unrealized Appreciation” (NUA) of the stock if certain requirements are met. NUA is the difference between the cost basis and current value which is the unrealized capital gain. However, the tax treatment received on a sale of employer stock within the plan and subsequent distribution would typically be the higher ordinary income rate. NUA rules are designed to address this discrepancy by allowing you to pay the lower capital gains tax rate on your employer stock.There are three rules which must be followed to qualify: First, the employer stock must be distributed in-kind, meaning, the plan must transfer your shares to you. You cannot sell the shares within the plan and repurchase them outside of the plan. Second, you must take a lump sum distribution of your entire retirement plan. You cannot just distribute the stock but would be required to close the plan and rollover any additional funds to an IRA. Lastly, the lump sum distribution must occur after a triggering event, which is typically having retired and reaching age 59 ½.
When taking advantage of the NUA strategy, ordinary income tax is due on the cost basis of the stock when the shares are distributed. The remaining gain on the stock is taxed as a capital gain when the shares are sold. This strategy makes sense when the benefits of paying a lower capital gains in the future are greater than the cost of paying tax on the basis today. Also to note, shares distributed via NUA do not receive a step-up in basis at death. There is no way to completely avoid some sort of taxation from being applied to the employer shares be it ordinary income or capital gain.
Here’s a simplified example of one way this can be beneficial: After 30 years, John, has retired from his company at age 65 with a monthly pension. He also has a 401(k) with a $500,000 balance with $100,000 held in his employer’s stock. His cost basis on the stock is $20,000. He will need $100,000 from his employer plan for a major home remodel this year. Should he simply take a distribution from his plan he would incur $100,000 in ordinary income and $24,000 in taxes assuming he is in the 24% tax bracket. Instead, he could take advantage of the NUA strategy and have his employer distribute the $100,000 stock to him and rollover the remaining $400,000 to an IRA. He now pays ordinary income tax on the basis of $20,000 ($20,000 * 24% = $4,800) and 15% long-term capital gains tax on the $80,000 of gain ($80,000 * 15% = $12,000). His total tax bill is $16,800 instead of $24,000, resulting a $7,200 immediate tax savings based on the lower capital gains tax rate.
There are many factors to consider in order to determine whether utilizing the NUA strategy is appropriate. As the example notes, for current income, an immediate benefit can be realized. We have seen many situations where there is a window of time between retirement and collecting Social Security and beginning required minimum distributions where tax brackets are likely to be lower. In these cases, paying the current ordinary income tax on the basis is often a minimal cost relative to the benefits of having the lower capital gains tax on the remaining gain. If you have basis in employer stock that is low relative to the current value of the stock it is certainly worthwhile to see if you can benefit from the NUA strategy.
