NUA Choice: A Tax Strategy to Consider If You Own Company Stock

Are you an employee who owns your corporate employer’s stock inside a company 401(k), employee stock ownership plan (ESOP), profit sharing plan, or other qualified employer-sponsored retirement plan?

If so, you should start thinking about what to do with the stock when you retire or leave your employer. Your decision can have big tax consequences.

Most people don’t think about it and simply roll the assets from their employer retirement plan into an IRA or a 401(k) with their new employer (if they’re changing jobs). Doing so is a simple rollover that has no tax consequences at the time.

But when you later sell the stock, you’ll have to pay tax on the proceeds at ordinary income tax rates, which can be as high as 37 percent (and could be going higher). This is so even though sales of stock are ordinarily taxed at capital gains rates, which are 0, 15, or 20 percent for stock held more than one year.

Planning point. You get no capital gains treatment when you sell stock out of a retirement account, such as an IRA.

A Tax Planning Alternative

There is another alternative. It might seem a bit risky, and it requires an outlay of some money up front, but it can save on taxes in the long run.

Instead of rolling over the stock into an IRA, a 401(k), or another retirement account, you transfer it into a taxable brokerage account. That year, the year of transfer, you must pay income tax at ordinary rates on your cost basis in the stock.

But you pay no tax on your stock’s appreciation (fair market value minus cost basis) until you sell it. This amount is called net unrealized appreciation (NUA).

If you sell the company stock in that year or any later year, you pay tax on your NUA at long-term capital gains rates, which are 15 percent for most people. You need not hold the stock for one year after the distribution to qualify for long-term capital gains treatment of your NUA.

One added benefit. Your NUA gain is not subject to the 3.8 percent Medicare surtax on net investment income.

Any additional appreciation in the stock at the time of sale also receives capital gains treatment—it will be taxed at the long-term capital gains rate if you hold the stock for more than one year from the distribution date. But on this additional appreciation above the NUA amount, you do have to pay the 3.8 percent net investment income surtax if your income is high enough.

Depending on various factors, such as the amount of NUA and your income tax rate when you sell the stock, you can save substantial taxes with this strategy.

Sounds easy. And it pretty much is easy. But to take advantage of NUA tax treatment, you must satisfy several strict requirements.

First, the distribution must be of employer stock held in a qualified employer retirement plan, typically a 401(k) or an ESOP. It makes no difference whether your employer contributed the stock to your account or you purchased it yourself with pre-tax dollars.

Stock held in a traditional IRA, SEP-IRA, or Simple IRA, or in any type of nonqualified deferred compensation plan, is not eligible for NUA treatment.

Next, you must distribute your employer stock6

• in kind, 
• as part of a lump-sum distribution, 
• and following a triggering event.

In-Kind Distribution

You must distribute the employer stock “in kind” to a taxable account. This means you must transfer the shares directly to your brokerage account. You can’t sell the shares and transfer the money, or transfer the shares to your IRA and then to a taxable account.

Lump-Sum Distribution

The stock must be distributed as part of a lump-sum distribution from your employer retirement plan. To qualify, you must distribute your entire vested balance in all assets from all qualified plans you hold with your employer within the same calendar year.

You don’t have to withdraw the entire amount at the same time, but your account balance must be zero by December 31.

Nor are you required to transfer all the plan assets into a taxable account. You can roll some assets into an IRA or the 401(k) plan of your new employer. For example, you can roll cash or mutual funds into an IRA.

Also, you don’t have to transfer all your employer stock into a taxable account. You can transfer some and roll the rest into an IRA. This means you can cherry-pick only the lowest-basis shares for the NUA distribution.

A Triggering Event

Your lump-sum distribution must be made after one of the following triggering events:

• you turn 59 1/2 years of age,
• you terminate your service with the employer, or
• you die or become disabled.
• Once you reach 59 1/2 years old, you can qualify for a lump-sum distribution at any time. If you are still employed, your company plan must allow in-service distributions.

If you take your lump-sum distribution before reaching age 59 1/2, you’ll have to pay the 10 percent early withdrawal penalty on your shares’ cost basis (not on their fair market value). But there is an exception to the penalty if you leave your employer after reaching age 55.

Estate Planning Benefits of NUA Treatment

Distributing your company stock to a taxable brokerage account has potential estate planning benefits. Because the stock is not in an eligible retirement plan, it is not subject to ordinary income taxes or the required minimum distribution rules that apply to IRAs and other qualified retirement plans after you reach age 72.

This means you can keep all the stock in your brokerage account until you die. Your heirs will receive a stepped-up basis for any appreciation in the stock during the time you held it in your taxable account. But your heirs receive no date of death step-up in basis for the untaxed NUA.10 The NUA is income in respect of a decedent, which means it’s taxed at capital gains rates to the heirs.

Is NUA Treatment for You?

NUA treatment isn’t always the best tax strategy. Unlike with a rollover into an IRA, you’ll have to pay income tax immediately on your stock’s cost basis. Whether this is advisable depends on many factors, listed below.

Your NUA amount. The larger your NUA, the more tax you’ll save with capital gains treatment. As a general rule, NUA treatment is advisable only where the stock’s tax basis is no more than 25 percent of its fair market value.

The tax due on your cost basis. You’ll have an up-front tax hit with this strategy. If the cost basis of your company stock is substantial, it could put you in a higher bracket.

Your age. If you’re relatively young, and you can keep the stock or its proceeds in an IRA where it can grow tax deferred for many years, NUA treatment may not be wise. The value of the multiple-year, tax-deferred growth can exceed the benefit of capital gains treatment of your NUA. On the other hand, if you are at or near retirement age and want to sell your company stock soon, NUA treatment can work very well.

Your tax bracket. Electing NUA treatment may not be advisable if you anticipate that your income tax bracket will go down substantially when you retire.

Takeaways

Here are five takeaways from this article:

1. If you are an employee with company stock inside a company 401(k), ESOP, profit sharing plan, or other qualified employer-sponsored retirement plan, you would usually roll the stock into an IRA when you retire or leave. With this rollover, you would pay tax at ordinary income rates when you take money out of your IRA.
2. Instead of rolling the stock into an IRA, you can elect NUA treatment by transferring the company stock into a taxable brokerage account. You must pay tax that year at ordinary income rates on your cost basis in the stock. But whenever you sell the stock, you pay tax on your appreciation at tax-favored long-term capital gains rates.
3. To qualify for NUA treatment, you must transfer all your vested employer retirement plan assets as part of a lump-sum distribution made after you reach age 59 1/2, leave your employer, or die.
4. Because the NUA stock is not in a retirement plan, it is not subject to the required minimum distribution rules. You can keep it in your account until you die. Your heirs then get a stepped-up basis for the appreciation in the stock during the time you held it in your taxable account.
5. NUA treatment works best for older employees who have substantial appreciation in their company stock. The stock’s tax basis should be no more than 25 percent of its fair market value.

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