Investors with large quantities of company stock inside a retirement plan may be missing out on an opportunity for a significant tax break when they retire. An often overlooked tax strategy known as net unrealized appreciation (NUA) allows investors to receive an in-kind distribution of their company's stock and pay income tax only on the average cost basis of the shares, rather than on the current market value.
Here is how net unrealized appreciation works: An employee is about to retire and qualifies for a lump-sum distribution from a qualified retirement plan. Under the more conventional strategy of simply rolling the distribution into an IRA, the investor pays up to 35 percent in ordinary income tax on the stock's value, including any gains, at the time of withdrawal.
By using the NUA strategy, the investor 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 investor to continue to defer tax on any appreciation that accrues from the time the stock is distributed until it is finally sold. At that point, the investor is taxed on the appreciated value at the long-term capital gains rate, which currently is capped at 15 percent.
Case in point: Rodney Hartwell, an executive of a medical supply company, was planning to leave at year-end. Hartwell had $100,000 worth of his employer's stock held in the company's 401(k) plan, with a cost basis of $20,000. A local investment advisor recommended that Hartwell roll his company stock into a low-cost IRA. He explained the advantages of the IRA and told Hartwell that his account would grow larger because the tax would be deferred and because of the potential returns of the hot mutual fund he was recommending. What the advisor did not explain (or perhaps did not understand) is that when Hartwell's IRA distributed income, he would not only be taxed ordinary income rates on his $20,000 cost basis but he would also be paying the highest rate on his $80,000 gain, 35 percent. If Hartwell simply took the stock out and did not roll it over into an IRA, his tax on the $80,000 gain would be treated as long-term capital gains and taxed at a maximum of 15 percent. Of course the $20,000 basis would be taxed as ordinary income. This tactic would result in a potential tax savings of $12,000 for Hartwell.
One caveat with the NUA tax break is that the distribution must be taken as a lump-sum distribution--not a partial distribution. In order to qualify for a lump-sum distribution, the employee must take the distribution within a year of leaving employment.
Relatively few financial advisors understand the net unrealized appreciation tactic, much less recommend it as a tax savings strategy to qualified clients. Most advisors are far more comfortable recommending that clients simply roll their company retirement accounts into IRAs when focused on the management of the money. However, this strategy could be a major mistake and cost you and your client later.
Following is a seven-step process designed to help you complete a successful NUA transaction. It is important to start early as these transactions may take several weeks. Note that employees should never ask for in-kind distributions of company stock in December; it is better to wait a month until the beginning of the next year because the entire distribution (both rollover and in-kind distribution) must be completed in the same calendar year.
Step One--Determine the amount of gain in the stock price. A NUA can be elected on some, all, or none of the shares in an employer-sponsored retirement plan. It doesn't make sense to elect this strategy on shares that were purchased for more than the current stock price. Look for shares that are currently selling for twice your client's cost basis.
Step Two--Get your cost basis in writing before starting the rollover. Obtain formal documentation from the plan of the cost basis of the company stock as well as the employer's promise to make an in-kind distribution of the company shares.
Step Three--Plan the sequence of transactions when the plan holds employer securities and other assets. You can roll the non-company stock portion of your client's plan into an IRA rollover account and transfer the company stock portion to the taxable (non-IRA) brokerage account. The company stock still qualifies for the tax break on the NUA. Employers are supposed to withhold 20 percent of distributions from a qualified plan for taxes unless it's a trustee-to-trustee transfer, or when the only remaining asset being distributed is employer stock.
Step Four--Complete the rollover to an IRA 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.
Step Five--Make sure the money is available to pay taxes on the cost basis. Your client will need to have money on hand to pay the income taxes on the cost basis for the shares that are distributed in-kind.
Step Six--Prepare a tax projection to determine the amount needed and be prepared to pay the tax man in April.
Step Seven--Have an exit strategy. The NUA distribution represents an opportunity to save taxes on low cost basis shares; however, the tax benefits are wasted if the company stock declines significantly after the distribution. You should take into consideration the future outlook for the company's shares. Assuming you are optimistic about the 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 unitrust (CRUT). Once the stock has been transferred to a CRUT, 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.
Final words of caution: The NUA strategy may not be the best decision for investors whose retirement savings are heavily concentrated in their employers' stock. An NUA distribution may not be a good idea if the company's outlook is bleak. You don't want to be holding a concentrated position in the stock when the price is declining. Also, remember that NUA doesn't mitigate the risks associated with improper diversification: An investor with 98 percent of his retirement account tied up in one stock may want to consider liquidating a portion of his stock position and distributing a smaller portion of the stock in-kind.
Even with these precautions in mind, for many investors, the NUA strategy still makes sense.
Rick Rodgers, CFP, is the founder of Rodgers & Associates (www.rodgers-associates.com), a fee-only advisory firm specializing in retirement planning.
-crop-215x144.JPG)
