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Craig’s Company Stock
Craig has worked for the same company for 35 years. He started at the bottom right out of high school making coffee and mail runs and now is the chief marketing officer of this growing long-standing company. Craig’s employer has allowed the employees to participate in the business success through a profit-sharing plan where every year Craig’s profit-sharing account is funded with shares of the company stock.
Over the years Craig’s employer has contributed shares cumulatively worth $500,000 on the dates of contribution that due to company growth are now worth $3,000,000. Craig is coming up on retirement and knows that any distribution out of the profit-sharing plan is subject to ordinary income tax rates. This leaves Craig’s $3,000,000 account only worth $1,890,000 after his 37% rate is applied. Just before Craig retires, he hears about the “Net Unrealized Appreciation” (NUA) rules and how they could save him $425,000 in tax. Before we dive into the NUA strategy we have to set the stage with the default retirement withdrawal rules.
Retirement Account Withdrawals
Certain employers prefer to fund employee retirement accounts with shares of company stock as opposed to cash. The employer can take a tax deduction today without any cash outlay and the employee is incentivized to look out for the long-term interest of the company. Although less common today, this is still a regular occurrence among particular employers.
Typically, any distribution from a pre-tax retirement plan such as a pension, 401(k), or IRA is subject to tax at ordinary income rates regardless of whether those retirement accounts held long-term capital gain assets. In other words, there is a tradeoff. The 401(k) or IRA benefits from a tax deduction up front and tax deferral over the years on income and gains inside the account however, upon withdrawal the entire distribution is taxable at ordinary rates. This treatment can make a significant difference on highly appreciated company stock such as Craig’s. Under the default withdrawal rules, Craig’s total tax liability once he eventually distributes his entire retirement account will be $1,110,000 ($3,000,000 x 37%).
Net Unrealized Appreciation
The IRS recognized the prevalence of awarding company stock in retirement plans and created special rules for the treatment of “Net Unrealized Appreciation” (NUA). The NUA rules state that if the company stock is distributed in-kind (not cash) as a lump sum distribution upon a triggering event then the cost basis is taxable as ordinary income, but the gains will be taxed at the beneficial long-term capital gains rates. This means Craig would pay tax at 37% on just the $500,000 and the appreciation of $2,500,000 would receive the lower 20% rate.
The NUA rules can be beneficial for individuals like Craig with highly appreciated company stock but in order to be utilized, individuals like Craig need to be careful to follow the three NUA requirements.
- The company stock must be distributed as shares of stock (not cash) directly to a taxable brokerage account. This step is counterintuitive and where errors often occur. Typically, a retiree would rollover their company retirement plan to an IRA at retirement however, rolling over the employer stock to an IRA would disallow NUA treatment.
- The workplace retirement plan must be completely liquidated in a lump sum distribution. The retiree cannot take partial distributions over multiple years or leave some dollars left in the company retirement plan for the NUA treatment to be allowed.
- NUA treatment is only available after a triggering event. This is the easiest requirement to satisfy as a triggering event is retiring from the company, reaching age 59 ½, death, or disability.
Craig’s Utilization of NUA
After hearing about how NUA could help save Craig over $400,000 in taxes and running the scenarios with his financial professional, Craig decides to pursue the NUA treatment. Craig’s retirement plan balance at work is comprised of $3,000,000 of company stock and another $1,000,000 of other stock market investments. Craig is 62 years old and is retiring from his career with his long-time employer and takes the following steps to receive NUA treatment.
- Craig instructs his employer to distribute the $3,000,000 to his taxable brokerage account. This distribution will generate a $185,000 tax bill for Craig as the $500,000 of cost basis in the company stock is subject to tax at ordinary income rates upon withdrawal.
- Craig instructs his employer to rollover the remaining $1,000,000 in the retirement plan to his IRA which completely empties his workplace retirement plan. This is a tax-free rollover and Craig will not have to begin taking IRA distributions until age 72.
- When Craig decides to sell any of the company stock now in a brokerage account the NUA (gain) of $2,500,000 will be subject to long-term capital gain rates when sold. If held and sold later, any gain or loss after the NUA event will be subject to normal short-term or long-term capital gain or loss treatment from the date of the distribution out of the plan.
Other Factors to Consider
NUA is often a great move for retirees with low basis employer stock in a retirement plan but there are numerous factors that should be considered before diving in.
Time Value of Money
Time value of money is a key player in determining whether NUA is an appropriate strategy. Craig will have to pay tax on the $500,000 of cost basis today at 37% to take advantage of the NUA treatment on the $2,500,000. If Craig were to roll over the entire $3,000,000 to an IRA he could avoid paying any tax for 10 years when required minimum distributions must start. There is a trade off between the tax rate savings 37% versus 20% and having to write a $185,000 check to the IRS today. This time value of money analysis results in NUA working best for those with low basis, highly appreciated employer stock. If Craig’s basis in the $3,000,000 was $2,000,000 he would have to pay $740,000 in taxes up front ($2M x 37%) to take advantage of the NUA treatment on the remaining $1,000,000. Under this scenario, Craig would be better off rolling the $3,000,000 over to an IRA and deferring the income recognition as long as possible.
This brings up another consideration, cash to pay the tax. To take advantage of the NUA strategy you must pay tax on the cost basis in the current year. If you plan to sell the employer stock immediately after withdrawal, liquidity to pay the tax is not a problem. But, if you plan to hold the employer stock to delay triggering the 20% tax on the NUA you might not have the available cash to pay the tax on the cost basis. In reality, this is rarely an issue due to the next factor worth considering: diversification.
In practice, highly appreciated employer stock can represent a large portion of an employee’s portfolio. As the employee transitions to retirement, it is often prudent to diversify the portfolio away from their previous employer’s stock. This diversification requires selling the company shares which under the NUA strategy is a taxable event at the long-term capital gain rate (20% for Craig). If Craig chose to forgo the NUA strategy and rolled over the entire profit-sharing plan to an IRA he could sell his employer stock within the IRA to diversify without triggering any tax as any income or gains within the IRA are not taxed until distributions are actually made from the IRA. This consideration boils down to timing as well and doing the math on paying tax at a lower rate today versus the higher ordinary income tax rate when later withdrawn from an IRA.
It is Not All or Nothing
It is rare that all employer stock awarded over the employee’s career has the same cost basis. Stock awarded early in a career likely has a much lower basis than the stock awarded closer to the employee’s retirement. As discussed, the lower the cost basis the more appealing the NUA strategy is. One important feature of the NUA rules is that an employee can choose to use the NUA treatment on just a portion of the employer stock. This is simply done by rolling over the lowest basis stock to a taxable brokerage account and rolling over the higher basis stock to an IRA.
The NUA rules can make a substantial difference in a retiree’s after-tax portfolio. There are several key choices to make that require careful analysis so if you, like Craig, could benefit from the NUA strategy, find and consult a competent professional to help determine the best course of action in pursuit of your unique and individual goals.