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Company Stock & NUA: Think Before you Roll

Ted BraunApril 19, 2018

Financial Planning

There are several benefits when working for a publicly traded company. One that we see most often is the accumulation of company stock within an employer sponsored retirement plan. These shares are often provided as a company match, contributed as a type of profit sharing or bought by the employees through bi-weekly contributions.

While it may seem like just another fund or investment in your retirement plan, it is in fact very different and needs careful evaluation when retiring or separating from a company after several years. The reason that company stock within an employer retirement plan requires careful consideration is because of something called Net Unrealized Appreciation or NUA.

Simply put, NUA is a special tax treatment afforded only to company stock within an employer-sponsored retirement plan. It is special for many reasons, but mainly because of the favorable tax treatment it provides for the shares withdrawn from the plan. As is the case with anything receiving favorable tax treatment, it comes with a few requirements that must be met.

How does it work?

Typically, any pre-tax money distributed and not rolled over from an employer sponsored plan is taxed as ordinary income to the recipient. Even with the new tax cuts taking effect this year, the highest marginal tax rate is 37%. NUA treatment of shares allows you to receive the stock from your employer plan, pay ordinary income on the cost basis of the shares, but capital gains tax on any appreciation when the shares are sold. Currently, capital gains rates are 0%, 15%, and 20%, which is a lot lower than 37%. To better explain, we’ve created the example below that helps highlight the benefit. 

Example

Jane has worked for XYZ company for 20 years. She has accumulated 10,000 shares of XYZ stock, that have an average cost of $5 per share (in total the shares cost $50,000 to purchase). The shares are now worth $25 per share or $250,000 in total. As you can see the shares have appreciated greatly over her time at the company with $200,000 in gains. Jane and her husband are in the 24% tax bracket and expect to remain in this bracket throughout retirement.  

Jane’s Options

  • Liquidate all her shares and roll them over as cash to her IRA, when money comes out of her IRA it will be taxed as ordinary income
  • Keep shares in her employer plan, liquidate and distribute cash from the plan as needed, when money comes out of the employer plan it will be taxed as ordinary income
  • Receive her shares and put them in her brokerage account, pay ordinary income taxes on the cost basis of $50,000, and capital gains tax on the appreciation when she sells the shares

Jane elects NUA and distributes her shares to her brokerage account and immediately sells them:

Stock Value Tax Treatment Tax Analysis
$200,000 Net Unrealized Appreciation Taxed as Long-Term Capital Gains, 15% $30,000 $250,000 worth of XYZ stock, paid out as shares to a brokerage account and sold immediately would have total taxes of $42,000
$50,000 Cost Basis Taxed as Ordinary Income, 24% $12,000


Jane withdrawals the funds directly from her employer plan, or rolls them over and then withdrawals:

Regular Withdrawal Transaction
Stock Value Tax Treatment Tax Analysis
$200,000 Net Unrealized Appreciation Entire $250,000 distribution taxed as ordinary income, 24% $60,000 $250,000 worth of stock rolled over then distributed or withdrawn directly from employer plan would have total taxes of $60,000
$50,000 Cost Basis

 

As you can see in the charts above, the same dollar amount distributed differently can result in a tax savings of $18,000. Very important to note that we’ve used the most basic example of NUA to highlight the potential favorable tax treatment. In most cases, it is not quite this black and white, which means an in-depth analysis should be done by your advisor and or tax advisor before making any final decisions.

Other potential benefits

The benefits of NUA will always be tied back to tax savings in some shape or form, but when and how the savings are realized is what makes it so unique. Some of the advantages are immediate, while some of the advantages may not be recognized for years.

Lower income tax benefits

The example above highlights an extreme example of a couple in a high tax bracket. Another potential advantage exists for those in lower tax brackets as well. If a couple’s taxable income is less than $77,200 in 2018, their capital gains rate is 0%. If the couple uses the standard deduction this means their total income would be $101,200. This means a couple could potentially draw retirement income from stock they elected NUA on and pay 0% tax on the NUA.

Charitable Giving

For those who are passionate about charitable giving, donating appreciated securities is an excellent option for reducing your taxes. When you donate shares you receive a tax deduction for the full fair market value of the shares. In addition, if the shares have substantially increased in value, you avoid paying the capital gains tax when you donate the shares. As an example, if you were to donate $110,000 of stock with a tax basis of $10,000, you would reduce your federal tax liability by $40,700 in the 37% tax bracket. You would also avoid paying capital gains tax of $23,800 (capital gain rate of 20% plus the net investment income tax rate of 3.8%) on the donation of the stock.  

Smaller RMD’s

As you approach age 70 ½, the IRS requires that you begin taking Required Minimum Distributions (RMD) out of your traditional IRA’s or employer plans. The less you have in these accounts, the smaller your RMD. Smaller RMDs mean more of your money stays invested in your IRA or employer plan, which means less taxes.

After-tax option

Some employers allow for after-tax contributions to be applied to the cost-basis of an NUA distribution. This is quite possibly the most attractive NUA option and is almost always advantageous. Since the cost basis in an NUA transaction is taxed as ordinary income, if it is an after-tax cost basis, there is no tax due on the cost basis.

Other considerations and potential drawbacks

As is the case with any major financial decision, both sides of the equation must be evaluated to make the best possible decision. The favorable tax treatment comes at a cost and is not right for everyone. First, let’s look at the requirements to be eligible for NUA tax treatment. All three of the requirements below must be met to be eligible.

  • Shares must be distributed from your employer plan “in-kind” or as shares
  • Distribution of shares must be part of a full “lump sum” distribution. Lump sum, for the purposes of NUA tax treatment, means that your entire account balance must be distributed by the end of the calendar year. This does not mean an all or nothing distribution, you can still roll over some of your stock or your other investments, but the account balance must be $0 on December 31 of the year of distribution.
  • You cannot elect a total lump sum distribution until after what is called a triggering event. A triggering event is one of the following: Death (not the best option), Disability (Also not the most favorable), Separation of service, or attaining age 59 ½. Important to note that while reaching age 59 ½ is a triggering event, you still must have the entire account balance at $0.00 at year-end which usually eliminates an in-serve withdrawal.

Under Age 59 ½

If you are under the age of 59 ½, the cost basis portion of your NUA distribution could be subject to the 10% early distribution penalty tax. This does not automatically eliminate NUA as an option, but should be factored into the decision.

Potential for additional and on-going tax

You do not have to sell any of the shares after they are distributed from your employer plan as part of an NUA transaction. If they are not sold, they will be in an after-tax brokerage and in some cases earning quarterly dividends which would be taxable in the year paid. Additionally, if shares are not sold the day they are paid out, any gain from that day forward is subject to the standard capital gains treatment. This means if they are held for less than year, short-term capital gains rates would apply to any appreciation from the day they were distributed. Short-term capital gains are currently taxed as ordinary income. 

Lack of Diversification

When part of your NUA planning involves holding onto the shares you have distributed for several years, there could be an issue with single stock risk, or a lack of diversification. Any time you are a holding a large position in just one single company stock, it adds tremendous risk to your portfolio given the potential volatility of individual equities.

Conclusion

In closing, there are no two client scenarios that are exactly the same. Be wary of any “blanket statements” as it relates to NUA. While an attractive benefit in some instances, it can be equally as detrimental if not evaluated properly. Every employer plan is unique and is governed by a different set of plan rules. Every employer is different in how they contribute stock to your plan and what they allow you to do with it when you leave. Take the time to understand the options you have available to you and work with your advisor or tax professional to make the best possible decision for you and your family.  If you would like to speak with an HFA advisor about your personal situation, please contact us at 610-651-2777!