Retirement can often be daunting to many, but you can turn this daunting event into something to really look forward to with the appropriate guidance and knowledge. In the years leading up to retirement, it’s important to consider different planning strategies and opportunities available to your specific circumstances. For example, if you were able to purchase your employer’s stock through your retirement plan, there are specific considerations you should take due to possible tax consequences once you retire. One of these considerations that many may be unaware of is Net Unrealized Appreciation (NUA).
How does NUA work?
You must first consider that distributions from your employer-based retirement plan may qualify for NUA only after a “triggering event.” A triggering event can be defined as a separation from service, reaching age 59 ½, disability, or death.
When utilizing the NUA strategy, you take a “distribution” from your plan for the entire balance. Partial distributions may disqualify you from NUA. When taking this “distribution,” you separate your retirement account assets between the employer stock and the remaining assets held within your account. The employer stock is then transferred into a non-qualified account. Generally, you pay the tax on the cost basis (price initially paid or value of the stock when it was obtained in the plan) of the employer stock at ordinary income tax rates in the year of distribution.
The shares that are now held in the non-qualified account are not taxed until you sell them. However, keep in mind any dividends you earn while retaining the stock are taxable when they are paid. When you sell the shares, you will pay taxes at the long-term capital gains rate on any appreciation above the original cost basis, which could be significant tax savings for some taxpayers.
Tax Comparison
Utilizing NUA
For example, let’s say you’ve accumulated $500,000 of pre-tax dollars in your employer-based retirement plan, of which $200,000 is employer stock. Let’s also assume the cost basis on the stock is $50,000. At retirement, you distribute your entire plan and transfer in-kind the $200,000 of employer stock to a non-qualified account and the remaining $300,000 to an IRA. You will pay ordinary income taxes on the $50,000 cost basis in the year of distribution. You decide to hold onto the employer stock and sell later when the stock has now grown to an accumulated value of $300,000. You will pay capital gains tax rates on $250,000 (accumulated value minus cost basis), which are currently far more favorable than ordinary income tax rates
Not utilizing NUA
We’ll use the same scenario as above, except when taking the distribution of the entire pre-tax retirement plan, you do a rollover to an IRA of the entire balance, including the employer stock. You will not pay any taxes when the distribution happens. However, for any withdrawals in the future, you will pay ordinary income taxes in the year you take the distribution from the IRA. This means all $500,000 of your original retirement plan is subject to ordinary income tax rates instead of only $300,000 when using the NUA methodology.
Other Considerations
- NUA is not for everyone and often only makes sense when the employer stock within your employer-based retirement plan has appreciated significantly.
- It can be very risky to keep a large portion of your overall portfolio allocated to the employer stock due to a lack of diversification in your portfolio. If your former employer goes bankrupt, then the stock may become worthless.
- Inheritance – If you choose not to sell the appreciated employer stock within the non-qualified account, your beneficiaries continue to benefit from your NUA strategy. When they inherit the stock, their new basis is the market value on your date of death. This means that any appreciation between when you first accumulated the stock within your employer-based retirement account and your date of death is never taxed. Only the growth since your date of death and the date your beneficiary sells the stock will be taxed at favorable capital gains tax rates. When inheriting IRA funds, the beneficiary’s distribution from the IRA is subject to their ordinary income tax rates.
- A change in the tax code could render the NUA strategy less effective and attractive in the future.
- If retirement significantly lowers your tax rate, you may see less benefit from the NUA strategy.
As always, it is important to consult with your advisor to see if this strategy will make sense for you. Many variables play into your financial situation and things to consider before making an informed decision.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or tax recommendations for any individual.
