March 2, 2020
When individuals terminate employment, an important question to consider is what to do with the retirement savings account. If they participated in an employee stock ownership plan (ESOP) or otherwise hold company stock in their investment portfolio, the answer to this question becomes especially important. As company shareholders, they have different options than other employees with 401(k)s or 403(b)s that do not include company stock. The net unrealized appreciation (NUA) rule will come into play if plan participants elect to disburse company stock in-kind rather than electing for the cash payout. In other words, how their retirement plan gets disbursed following termination – if it even does – will make a difference. To help clients, prospects, and others, Wilson Lewis has provided a summary of key issues to consider below.
NUA can be more simply referred to as an embedded capital gain. It is calculated as the market price less the cost basis of company stock. It is an election that plan participants can make when they take a lump-sum, in-kind distribution from their retirement account. Unlike distributions of other investments, distributions of company stock are taxed at ordinary income rates rather than more favorable long-term capital gains rates. The NUA rule seeks to alleviate this burden by transforming a portion of the ordinary income into long-term capital gains. Without the NUA rule, individuals could be penalized by having to pay more in taxes.
The NUA rule can help many individuals save money, but only when all the following statements are true.
The stock distribution is made in-kind.
The distribution must be of company stock, not the cash value of that stock or stock options.
The distribution is made directly from the employer-sponsored plan.
Individuals cannot first roll company stock into an external IRA before liquidating their shares.
The withdrawal is part of a lump-sum distribution.
Retirement plan assets can be directed to different places (for example, some can be rolled into an IRA, some converted to a Roth, and the rest taken as a distribution), but the entire account balance must be removed from the company plan by the end of the tax year.
The distribution follows a “triggering event.”
The distribution can only occur after a termination, retirement, death, or disability.
The company stock is highly appreciated.
Individuals would not benefit from the NUA rule if company stock depreciated from its cost basis.
The individual can afford to pay income tax on the cost basis of the distributed stock.
Electing into the NUA rule will require individuals to pay some taxes upfront. This brings us to the mechanics of the election.
Under the NUA rule, individuals will be taxed immediately on the cost basis of their shares at ordinary income tax rates. This is true whether they take that income home or transfer it into another retirement or brokerage account. The value surpassing the cost basis (the NUA) is subject to long-term capital gains rates but only becomes taxable when the shares are sold. If company shares are held in a separate account for years before they are sold, any subsequent appreciation will also get taxed at long-term capital gains rates.
The NUA rule can indeed help individuals save taxes. For a taxpayer whose marginal tax rate is in the 32% bracket, shifting income from ordinary income rates to 15% capital gains rates can result in a compelling However, it’s important to understand this election may not be beneficial for everybody.
The first issue some taxpayers may have is managing the initial tax bill. The NUA rule requires individuals to pay taxes on the cost basis upfront, and the tax bill at ordinary rates can be bigger than anticipated. The second issue will be with the timing of the distributions. If taxpayers forego the NUA election, they will owe ordinary income tax on both their cost basis and NUA, but the tax bill can be deferred for years, if not decades. Over the long term, the math might just point to foregoing the election.
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The NUA rule is complex and tax-saving potential is completely dependent on an Atlanta individual’s circumstances. The only way to determine if it makes sense for your situation is to work with a qualified tax professional familiar with the NUA rule. If you have questions about the information outlined above or need assistance with a tax planning or compliance concern, Wilson Lewis can help. For additional information call us at 770-876-1004 or click here to contact us. We look forward to speaking with you soon.