If you have employer stock in a 401(k), ESOP, or other qualified retirement account - stop and discuss net unrealized appreciation (NUA) with your financial advisor, accountant, and estate planning attorney before you take a lump-sum distribution and roll the plan into an IRA.
Individuals with employer stock in a 401(k), ESOP, or other qualified retirement plan may be entitled to special income tax treatment.
Unfortunately, most clients are never told the employer stock in their 401(k), ESOP, or other qualified retirement plan may qualify for special NUA treatment. They are typically advised, without further discussion, to roll the entire lump sum distribution, including the employer stock, into an IRA. They are never told that they might save a substantial amount in taxes by distributing the employer stock in kind, and rolling the rest of the qualified plan into an IRA.
If you withdraw employer stock from a qualified retirement plan and receive the stock in kind (rather than rolling it into an IRA), you will pay ordinary income tax only on the original cost basis. You will not be subject to required minimum distributions, and when you subsequently sell the employer stock, you will only pay capital gain on the appreciation, as opposed to ordinary income tax.
For example, suppose employer stock in a 401(k) has a cost basis of $5,000, and a fair market value of $100,000. If the employee takes a lump sum distribution from the 401(k) and transfers the employer stock into a brokerage account, this is what happens:
- Ordinary income tax is immediately due on $5,000 and,
- When the employee subsequently sells the employer stock, the remaining $95,000 (referred to as the net unrealized appreciation, or NUA) is subject to long term capital gain tax, as opposed to ordinary income tax. Any change in the value of the employer stock after the distribution in kind will be treated as short or long term gain or loss, depending on when the stock is sold.
Every individual who has employer stock in a qualified plan needs to be aware of the potential tax savings associated with NUA treatment. Once employer stock is rolled into an IRA, any NUA tax savings are lost, forever.
Generally, you can only take advantage of NUA treatment if you receive employer stock as part of a lump-sum distribution. For NUA purposes, to qualify as a lump-sum distribution, the following three (3) requirements must be met:
- A “triggering event” must occur. Generally, a triggering event occurs when an employee dies, attains the age of 59 1/2, separates from service, or (if self-employed) becoming disabled.
- It must be a distribution of the entire balance, within a single tax year, from all of the employer’s qualified plans of the same type (i.e., all pension plans, all profit sharing plans, or all stock bonus plans).
- The company stock must be distributed as actual shares. The stock cannot be converted to cash before distribution.
There is only one exception: employer securities purchased with after-tax contributions will be eligible for NUA treatment, even if a distribution doesn’t qualify as a lump-sum distribution.
Employers are notorious for not being able, or refusing, to provide the cost basis for employer stock held in a qualified plan. If you take a lump-sum distribution, the cost basis is needed for NUA calculation, so you should keep your own cost basis records.
There are also disadvantages to NUA treatment:
- The rollover IRA tax-deferred growth benefit is lost.
- Holding a significant amount of post-distribution employer stock may not be appropriate. The need to diversify or liquidate the stock for cash flow purposes will trigger capital gain tax, unless combined with another estate planning vehicle, such as a charitable remainder trust.
- Stock held in an IRA or employer plan is entitled to significant protection from creditors. That protection is lost if the employer stock is distributed in kind to take advantage of NUA treatment.
In certain cases, it might be best to roll the employer stock into an IRA.
In general, NUA treatment is appropriate for individuals who own highly appreciated employer stock in a qualified plan. However, whether it is appropriate in a given situation will depend on a number of variables, including a person’s age, creditor protection needs, timeframe for diversifying or liquidating the employer stock, estate planning goals, etc. Before deciding whether to take advantage of NUA treatment, be sure to speak with, and get a recommendation from, your financial advisor, accountant, and estate planning attorney.
The script is typically the same: “When you take a lump-sum distribution from a 401(k), ESOP, or other qualified retirement plan, you should roll everything, including any employer stock, into an IRA.” Rarely is there any mention of NUA treatment. Don’t follow that script. Write your own, taking the possible tax savings into account.
Every year, taxpayers seek private letter rulings from the IRS, asking for permission to take employer stock out of a rollover IRA, so they can take advantage of NUA treatment. The answer from the IRS is always the same - “No!” So, don’t bother trying.
A number of financial advisors recommend keeping post-distribution employer stock in its own account. Once the stock is mingled with other other non-qualified investments, tax calculations can be burdensome.
Even with NUA treatment, a 10% penalty may apply if you take a lump-sum distribution under the age of 59 1/2, unless you qualify for an exemption under Internal Revenue Code Section 72(t) (e.g. qualified domestic orders, unemployed individuals for health insurance premiums, first home purchase, or called to active duty).
If you die with employer stock in your 401(k), ESOP, or other qualified plan, your plan beneficiary(ies) can also use the NUA tax strategy. If NUA tax treatment is elected, however, the beneficiaries will not get a step-up in basis for the employer stock, despite the fact they receive the stock as a result of your death.
If you die after you’ve received the distribution of the employer stock, and elected NUA tax treatment, your heirs will have to pay long-term capital gain tax on the NUA (i.e., the difference between the cost basis of the employer stock and the fair market value of the stock on the original date of distribution). However, all appreciation as of the date of your death in excess of NUA will forever escape taxation, because the stock will get a step-up in basis.
Failing to take NUA treatment into account is the #1 mistake people make with respect to their qualified retirement plans. If you own employer stock in a 401(k), ESOP, or other qualified plan, be sure you and your advisors consider the tax savings available to you before you roll the entire plan, including the employer stock, into an IRA.
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The material in this article is intended to provide you with guidance regarding certain tax and nontax issues. It does not constitute, and should not be treated as, legal advice regarding the use of any particular tax or non-tax planning technique or the consequences associated with any such technique. Although every effort has been made to assure the accuracy of this material, the author does not assume responsibility for any individual’s or entity’s reliance on the written information contained in the article. You should independently verify all statements made in the article before applying them to a specific situation, and should independently determine both the tax and nontax consequences of using any particular technique before recommending that technique or implementing it on behalf of yourself or any third party.
Circular 230 Disclosure: U.S. federal tax advice in the article is not intended or written to be used, and cannot be used, by any person for the purpose of avoiding tax penalties that may be imposed with respect to the matters addressed. Some of that advice may have been written to support the promotion or marketing of the transaction(s) or matter(s) addressed within the meaning of IRS Circular 230, in which case, be advised that the advice was written to support the promotion or marketing of the transaction(s) or matter(s) addressed, and you should seek advice based on your particular circumstances from an independent tax advisor.
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