Individuals who own company stock in an employer-sponsored qualified retirement plan may be able to benefit from an Internal Revenue Service (IRS) tax rule that provides an additional distribution option for such a holding. According to Vanguard’s 2014 research on nearly 1,500 qualified plan sponsors, 15% of all plan participants utilize company stock in their employer’s qualified retirement plan. While this figure has declined from the 26% level it once was in 2005, there are still a great number of employees who choose to include company stock in their account. If you are one of these individuals who own company stock in an employer-sponsored qualified retirement plan, you may be able to benefit from a strategy pertaining to net unrealized appreciation (NUA).
Net unrealized appreciation is the difference between the cost basis (price of shares when initially purchased) and current market value of company stock that is held in an employer-sponsored qualified retirement plan. For example, let us say that an employee purchases or obtains 50 shares of company stock in their qualified employer plan at a share price of $20, and ten years later the stock grows to $40 per share. In this scenario, the current market value of the shares would be $2,000 and the cost basis would be $1,000, amounting to a $1,000 difference. This gain of $1,000 since the shares were purchased is the NUA.
So, what makes NUA worth mentioning after all? The answer to this lies in the options that the Internal Revenue Service (IRS) allows for the treatment of the distributions of NUA. If an individual either directly withdraws the funds from their qualified retirement plan or withdraws the funds after rolling them to an Individual Retirement Account (IRA), the total distribution will be taxed at their ordinary income tax rate, which in 2017 is 39.6% for those in the highest tax bracket.* However, if that individual were to distribute the company stock in their qualified plan to a taxable brokerage account, they would be subject to ordinary income tax on the cost basis, but would pay the long-term capital gains tax rate on the NUA when the shares are sold (provided that the funds are held outside the 401(k) account for at least a year). This difference in treatment with the NUA portion of the account may allow individuals to potentially benefit from a lesser tax on the appreciation of their company stock, as the long-term capital gains tax rate for 2017 ranges between 0% and 23.8%* (depending on an individual’s income tax bracket).
The choice of whether to distribute your NUA to a taxable brokerage account or roll over the company stock to an IRA is highly dependent on how much the stock has appreciated since initial purchase/obtainment. Generally speaking, if your cost basis is 50% or less of the current market value of the shares, you may want to consider distributing the stock and using an NUA strategy. However, there are other items to keep in mind before electing to implement an NUA strategy. Take time to evaluate the strength of the company itself, as well as your overall willingness to hold the stock for an extended period of time. If you do elect to employ an NUA strategy, please be aware that you are thereby accepting the increased risk of single stock concentration. It is also important to ensure that you have the cash that would be needed to pay the taxes owed. Please note that the NUA approach only applies to the stock for the company that you are/were employed at and within the company plan. Additionally, if you employ this strategy before you reach age 59 ½, or have separated from the company before turning age 55, you may be subject to a 10% penalty on the cost basis.
Ultimately, the decision of distributing your NUA to a taxable brokerage account or rolling over the company stock to an IRA requires a holistic analysis of your financial needs during retirement, as well as the tax circumstances of each strategy. Whether or not an NUA strategy applies to you, having a sound plan that addresses both your tax situation and liquidity needs throughout retirement should remain top of mind.
*Please note that these rates could change depending on the outcome of the new administration’s tax plan proposal.