Tax Break for Company Stock Gains | Lord Abbett
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Retirement Perspectives

Net unrealized appreciation is a generous tax break that is often overlooked

Read time: 5 minutes

When plan participants retire or terminate their employment and opt for a tax-deferred rollover of their 401(k) plan assets to a rollover IRA, it’s usually a prudent decision. However, let’s say the participant has highly appreciated company stock. If that is the case, it could be more advantageous to cash out the stock portion and pay immediate taxes.  

Why?  Because there is a tax break for individuals with highly appreciated stock called “net unrealized appreciation” (NUA). Although it’s one of the more generous tax breaks offered, it’s commonly misunderstood or overlooked.

What is NUA and how does it work?

 

Net Unrealized Appreciation (NUA) enables you to pay lower capital gains rates on your company stock investment gains versus paying the typically higher ordinary income tax rates.

 

  • NUA is the difference in value between the average cost basis of the shares and their current market value. When you deploy this little-used IRS rule, you pay lower capital gains rates versus the typically higher ordinary income rates. The greater the difference between a participant’s income tax rate and the long capital-gains tax rate, the greater the potential savings.
  • NUA allows you to exchange ordinary income tax (maximum rate of 37%) rates for long-term capital gains rates (maximum rate of 23%; including the 3.8% Medicare surtax on net investment) for appreciated company stock held in a workplace retirement plan. The potential savings can be substantial. Taxes are owed only on the original cost to purchase the shares – not the current market value. The NUA (stock price appreciation from the time it was acquired until the time it’s distributed) is taxed when the stock is sold.
  • Plus, the one-year holding period otherwise required to qualify for long-term capital gains treatment is automatically satisfied, regardless of how long the stock is held outside the plan (i.e. inside the brokerage account)!
  • If your 401(k) account includes highly appreciated company stock, to achieve the tax break, you should NOT roll over the company stock assets to an IRA, instead, move the stock to a brokerage account and pay tax on it immediately. You can elect to defer the tax on the NUA until the stock is sold. However, you can roll the rest of the plan assets (mutual funds, etc.) over to an IRA.
  •  The participant is not subject to current income tax on the stock’s appreciation (i.e. the NUA) or other assets (non-company stock, such as mutual funds) rolled over to their traditional IRA. Income tax would be due on the cost basis (amount it cost to purchase the stock) of the stock. Either your employer or your 401(k) provider will provide both the stock’s cost basis and NUA.

You can’t make a mistake.  The consequences are serious.

There is a maze of rules that must be adhered to or NUA will be forfeited. For example, highly appreciated company stock MUST be transferred a brokerage account. Don’t make the (all too common) mistake of rolling over company stock to an IRA.  Why? If the appreciated company stock is rolled over to an IRA, the NUA tax break is lost, and any IRA distribution will be taxed as ordinary income.

 

NUA rules

  • To qualify for NUA treatment, the payment from the retirement plan must be a “lump-sum distribution.” This requires all a participant’s account balances in all “like” plans of the same employer to be distributed in a single tax year.  In other words, all retirement accounts must be fully liquidated and thus have a balance on December 31 of zero.
  • A lump-sum distribution must occur after a certain stated event referred to as a “triggering” event. NUA treatment requires one of the following events to occur:
  1. Death
  2. Age 59 ½ (only if plan allows)
  3. Separation from service (not allowed for individuals that are self-employed)
  4. Disability (only allowed for individuals that are self-employed)
  • This doesn’t just mean all the stock must be taken out of the plan; it means the entire account must be distributed including non-stock assets (e.g. mutual funds). If there is any balance in any of the like plans at the end of the year, the NUA tax break is lost.
  • In other words, NUA is not an all or nothing proposition. While you still have to take a lump sum distribution of your employer plan, you can choose to use only some of the company stock to take advantage of the NUA and roll over the rest of the company stock to an IRA. For example, IRS rules permit an individual to facilitate an NUA distribution for just part of their account and roll over the rest directly to a traditional IRA.
  • Any appreciation from the distribution date through the date of sale does not automatically qualify for the long-term capital gain rate. Instead, you would need to hold the stock the required time (1-year) to qualify (beyond the NUA) for lower beneficial long-term rates.
  • NUA can also apply when company stock is distributed to a beneficiary if he or she receives a lump-sum distribution from the plan.
  • NUA is reported on IRS Form 1099-R. https://www.irs.gov/pub/irs-pdf/f1099r.pdf
  • For more information on these complex rules, as well as situations that trigger additional tax restrictions, review IRS Publication 575, Pension and Annuity Income.

PRACTICE TIP: Generally, a 401(k) distribution that occurs before age 59½ is subject to a 10% early distribution penalty unless an exception applies. NUA is not considered an exception to the penalty, BUT the penalty applies only to the amount an individual paid for the stock; in other words, the penalty applies only to the taxable portion of the distribution. However, NUA becomes even more advantageous if the participant is age 59½ or older or was age 55 or older when they separated from service in the year, they reach age 55 or later. Here, the 10% early distribution penalty tax is waived.

EXAMPLE:  Let’s say Tom left his job at Life’s a Dream Inc. and his 401(k) account is valued at $500,000. $200,000 of that total is invested in Life’s a Dream stock that Tom purchased for $50,000 (cost basis). Tom can transfer $200,000 of the company stock to a taxable brokerage account, paying ordinary income tax only on the original $50,000. The increase or appreciation ($150,000) is the NUA, which means Tom would qualify for long-term capital gains rates upon selling the stock—even if sold within the one-year holding period. The remaining 401(k) non-stock (i.e., mutual funds) balance of $300,000 can be rolled tax-free into a traditional IRA.

At any time, Tom can sell the stock and pay taxes on the appreciated amount at long-term capital gains rates. Whereas the non-stock assets rolled over to an IRA would be taxable at ordinary income upon taking a distribution. Thus, NUA creates an opportunity to convert unrealized gains from ordinary individual income rates into long-term capital gains rates.

Things to check on

  • Your employer or 401(k) provider will give you your cost basis.
  • Several retirement plans hold employer securities in a “stock fund.” Check with your plan administrator or tax professional to determine whether the securities qualify for NUA treatment.
  • If you are the beneficiary of a company plan check if that plan includes highly appreciated company stock. You may be eligible to claim the NUA tax break.

Key Takeaways

  • NUA, an often-overlooked tax break called enables you to pay lower capital gains rates on your company stock investment gains versus paying the typically higher ordinary income tax rates.
  • To achieve the tax break, you should NOT roll over the company stock assets to an IRA but instead, move the stock to a brokerage account and pay tax on it immediately.
  • There are numerous factors to consider determining whether NUA makes sense, and the rules themselves are complex. It’s best to discuss this scenario with your tax professional.

 

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett's products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

The views and opinions expressed are as of the date of publication and are subject to change based on subsequent developments and may not reflect the views of the firm as a whole. The information discussed is only for illustrative purposes and is intended to provide general investment education and is not intended to provide legal, tax or investment advice. It is not intended to be relied upon as a forecast or research regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment or serve as a recommendation or offer to buy or sell securities.

Copyright © 2021 Lord, Abbett & Co. LLC. All rights reserved.

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