5 Steps to a Successful NUA transaction

Retirees who own their employer’s stock in their 401(k) plan have the potential for huge tax savings using an often-overlooked tax strategy known as net unrealized appre­ci­ation (NUA).

How does an NUA work?

Here’s an example. An employee is about to retire and qualifies for a lump sum distri­b­ution from a qualified retirement plan. He elects to use the NUA strategy, receives the stock, and pays ordinary income tax on the average cost basis, which repre­sents the original cost of the shares. This strategy allows the tax to be deferred on any appre­ci­ation that accrues from the time the stock is distributed until it’s finally sold.

Note: an NUA distri­b­ution must be taken as a lump sum distri­b­ution, not a partial lump sum distri­b­ution. In order to qualify for a lump sum distri­b­ution, the employee must take the distri­b­ution all within the same calendar year.

This strategy isn’t quite as advan­ta­geous as it once was prior to the American Taxpayer Relief Act of 2012 (ATRA12) and the Medicare Surtax of 3.8% on net investment income. Both of these tax laws took effect in 2013 and generally impact taxpayers with income over $250,000. ATRA12 raises the rate on long term capital gains from 15% to 20% for taxpayers with income over $450,000. The Medicare Surtax affects capital gains but distri­b­u­tions from a retirement account are exempt. Taxpayers affected by these changes will need to review the NUA strategy carefully to determine if it still makes sense.

The Tax Cuts and Jobs Act of 2017 lowered tax brackets on ordinary income but left capital gains rates unchanged. Careful planning will be required to make sure the NUA strategy is still the best option. A retiree who is close to age 72 will need to take into consid­er­ation how the NUA strategy will impact required minimum distri­b­u­tions (RMD). NUA reduces the value of a retirement account by removing what could be a signif­icant portion of the account value. Capital gains could be allowed to grow untaxed long after reaching age 72.

Follow these Steps for a Successful NUA Transaction

Before exercising a distri­b­ution or rollover, follow these five steps designed to help you under­stand what it takes to complete a successful NUA transaction.

1. Start early—the NUA trans­action may take several weeks. Be sure to obtain a written copy of your cost basis from the plan sponsor before initi­ating the rollover. You should also request formal documen­tation showing your employer’s promise to make an in-kind distri­b­ution of the company shares.
2. Determine the amount of gain in the stock price. In an employer-sponsored retirement plan, you can elect an NUA on some, all, or none of the shares. As a rule-of-thumb, you only want to use this strategy on shares currently selling for twice your cost basis.
3. Select the sequence of trans­ac­tions when the plan holds other assets in addition to employer securities. You can transfer the company stock portion (which still qualifies for the tax break on the NUA) to a taxable (non-IRA) investment account, and you can roll the non-company stock portion of the plan into an IRA rollover account. You should execute the IRA rollover first for all assets except the company stock, then the NUA shares can be distributed in-kind, with nothing to withhold for the IRS from either trans­action. Note that unless it’s a trustee-to-trustee transfer, or the only remaining asset being distributed is employer stock, your employer is required to withhold 20% of distri­b­u­tions for taxes.
4. Know Your Liabil­ities. You should have your tax profes­sional prepare a tax projection to determine the amount needed, and be prepared to pay the IRS in April.
5. Prepare an exit strategy. Assuming you’re optimistic about your company’s future and proceed with the in-kind distri­b­ution, you should still have an exit strategy if the stock starts to decline. One possi­bility would be to give some or all of the stock to a chari­table remainder trust (CRT). Once the stock is trans­ferred to a CRT, the shares can be sold by the trustee and reinvested in a diver­sified portfolio that can provide lifelong income to the donor. The chari­table deduction might even offset most of the tax oblig­ation on the cost basis.

An NUA distri­b­ution may not be a good idea if the company’s outlook is bleak. The tax benefits are wasted if the company stock declines signif­i­cantly after the distri­b­ution. An investor with 98% of their retirement account tied up in one stock may want to consider selling a portion of the stock position with the highest cost. Use the NUA strategy to distribute a smaller portion of the stock in-kind. Second, never attempt to complete an NUA distri­b­ution late in the year. It’s better to wait until the beginning of the next year, because the entire distri­b­ution (rollover and in-kind distri­b­ution) must be completed in the same calendar year.

Our team of advisers guides our clients through tax strategies to help them take advantage of oppor­tu­nities and avoid mistakes. We believe retirement planning is more than just picking invest­ments. You should have a partner to guide you through today and lead you to tomorrow.

Rick’s Tips:

NUA allows the tax to be deferred on any appre­ci­ation that accrues from the time the stock is distributed until it’s finally sold.

Distri­b­u­tions must be taken as lump sum distri­b­u­tions, not partial lump sum distributions.

In order to qualify for the NUA treatment, an employee must complete the entire distri­b­ution within the same calendar year.

Origi­nally published March 2018