When reviewing retirement assets, you may want to discuss the net unrealized appreciation rule (NUA) if your client owns appreciated company stock in a qualified 401(k) plan. Clients may not realize they may benefit from the tax flexibility provided by the rule. Presenting this alternative can differentiate you from other advisors or investment firms who lack technical expertise around rollover options for participants leaving company retirement plans.
The Profit Sharing Council of America reports that 18% of assets in employer-sponsored retirement plans are held in public stock. That’s a segment of the market totaling more than $500 billion.
How the strategy works
When an employee leaves a job or gets ready to retire and decides to roll over retirement assets into an individual retirement account, a common tendency is to include all of the assets. Eventually, when that money is distributed, it will be taxed as ordinary income.
But clients with appreciated company stock may be able to use a more tax-efficient strategy. Under the NUA rule, employer shares of company stock are instead transferred in kind to a regular brokerage account. While this is a taxable event, it is not a sale. Accordingly, the income taxes are applied but only on the cost basis, or purchase price, of the shares, and not on the fair market value of the stock. The difference between the fair market value and the cost basis, the appreciation or “NUA”, is not taxed when the stock is distributed from the employer plan.
Once the stock is transferred, clients can choose to sell it. The NUA is then taxed at the long-term capital gains rate, which is currently 15% — significantly less than ordinary income tax rates in many instances.
- The NUA rule can be applied on just a portion of the company stock holdings. In fact, company shares may be broken up by lots, allowing clients to gain the most advantage by choosing the shares with the lowest cost basis.
- The remaining assets in the plan can be rolled over into an IRA.
- NUA may be used for separate plans.
There are different scenarios along the timeline to retirement where it may be more advantageous to use the NUA rule.
The “net unrealized depreciation” strategy for company stock that has decreased in value
Even depreciated company stock can be used for a tax advantage.
If the company stock is trading below the cost basis, a client may choose to sell and repurchase the shares if there is an expectation that the stock’s value may turn around in the future. If the plan allows the participant to sell and buy back the stocks within the plan, the transaction can reset the cost basis to the new purchase price (depending on how the plan provider tracks cost basis of employer stock shares within the plan). Unlike typical stock transactions resulting in a loss, the wash sale rule does not apply to transactions occurring within ERISA plans.
The hope of the participants, if they continue to work for the company, is for the stock price to increase in the future and that they will be able to take advantage of the appreciation. The lower the cost basis, the greater potential for NUA in the future if the stock rebounds.
Clients also may need to be reminded that strategies such as the NUA rule need to be considered, under guidance from an advisor, in the context of the clients’ overall financial situation and retirement plan. Incurring a tax liability of any kind may have an impact on a tax bracket, total income, deductions, and other tax considerations.