Appreciating the NUA

office spaceWhen it comes up in casual conversation that I am self-employed, people usually picture the clichés of “going to work in jeans” and “setting my own hours” often associated with self-employment.  While some of that is true, I often tell people being self-employed has a lot of advantages but also a lot of disadvantages.  Without going into a laundry list of advantages & disadvantages, I will say one of the things I miss about working for a large company is the ability to fully participate in what is often a generous matching program with 401(k) retirement savings programs.  This is the percentage “match” of pre-tax contributions that is essentially free money and is a no-brainer when it comes to saving for retirement.

While some companies use good ole’ cash as the asset to match employer contributions (my preference), some employers instead match in the corporation’s stock which could help or hurt you (depending on the stock performance) but in either case, this matching in stock introduces some complexities when it comes time to retire.  Specifically, if an employee amasses a large position in employer stock after years and years of contributions and “autopilot” matching, they may suddenly find themselves WAY overleveraged to a single company’s stock in what should really be a relatively conservative portfolio just before or in retirement.

So what is one way to “fix” this in a tax-advantaged way?  Enter the NUA (net unrealized appreciation).  (Obligatory disclaimer:  I am NOT a CPA so please consult your CPA or enrolled agent before making any final decisions on this strategy).  The net unrealized appreciation is a way to take the stock “in kind” as part of a lump-sum distribution and moving that stock in to a taxable account.  The primary reason?  In short, to take advantage of what are presently lower capital gains tax rates compared to ordinary income rates.

Now there are a lot of moving parts around this and each person has individual circumstances that could sway the decision to do this one way or the other but in my view, the strategy is at least worth investigating as it could save a retiree a bundle on income taxes over a long period of time. (Note: the distribution must be the entire balance, in a single year, from the employer’s plan and the employee must be paid after age 59 ½ or separated service, disabled or dead.  See?  I told you there were a lot of moving parts- that’s just the tip of the iceberg.)

So here’s how this works.  Let’s say someone has worked at company XYZ for 35 years and in that time has accumulated a large position in the shares by buying some shares outright within the plan and also getting the “match” with the shares.  Assuming the stock has gone up over the last 35 years, this means they have many shares at a low cost-basis (price they paid) compared to the current stock price.  The NUA allows someone to take the distribution but only be taxed at ordinary income rates on the cost basis and NOT the fully appreciated value.

So if someone had $1,000,000 in XYZ and a cost basis on all their shares at $200,000 they would distribute the shares and pay ordinary income tax on only the $200,000 in the year of distribution while the remaining $800,000 of stock would now be in a taxable account and would not be “required” to be withdrawn like with an RMD on an IRA.  While that tax bill on the $200,000 is nothing to sneeze at, it could be much lower over time than rolling over the full $1,000,000 to an IRA, then taking distributions (for living expenses) and paying ordinary income tax rates on all those larger distributions.  To put some real numbers around this, a married couple filing jointly pays a 28% marginal tax rate on income between about $151,000 and $230,000.  So assuming they paid a blended rate of maybe 25% the year they take distributions (due to other income) that would be a tax bill in the first year of $50,000 (25% on $200,000).  However, they would now have a smaller IRA ($200,000) and a larger taxable stock account ($800,000) that they are NOT required to take distributions on and when they do, they would sell for the stock and pay capital gains rates, which for most would be about 15% on the gain.

As I stated, there are many other restrictions and moving parts associated with this decision including age, other income sources, dividend yield on the stock, plans for heirs, opinions on the future performance of the stock, etc.  So the purpose of my article is not to necessarily diagnose a personal situation because everyone is unique.  In fact, I had a client in this exact scenario and due to some unique circumstances we actually chose NOT to employ the NUA.

The point is to drive awareness that this strategy exists in the dusty, cob-webbed sections of the tax code and should be seriously considered.  This analysis requires some long discussions, some geeky spreadsheets (which I happily create) and some tough calls.  But if you do find yourself in this unique circumstance of high exposure to low cost-basis employer stock in your employer’s retirement plan and you’re thinking about retirement soon, I implore you carefully evaluate this strategy.  So as an employee of a big company, you may have not been able to “create your own hours” or “wear jeans to work”.  But – the ability to fully utilizing the NUA (if appropriate) could potentially help turbo-charge the value of all those years “punching the clock”.

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