If you participate in a 401(k), or other qualified retirement plan that lets you invest in your employer’s stock, consider the tax deferral opportunities of net unrealized appreciation.
When you receive a distribution from your employer’s retirement plan, in general, the distribution is taxed as ordinary income. The most common way to avoid immediate taxation is to roll the plan assets over to an IRA. However, when you receive
distributions from the IRA, they will be taxed as ordinary income.
But, there is another option available if your retirement plan distribution includes employer stock. You may be able to defer paying tax on the portion of your distribution that represents net unrealized appreciation (NUA). You will not pay tax on the NUA until you sell the stock. In addition, the NUA will be taxed at long-term capital gains rates which can result in significant tax savings.
The NUA includes the cost basis (the stock value when contributed to, or purchased by the plan) and the increase in value above the cost basis until the date the stock is distributed to you.
The increase in value above the cost basis at distribution is the NUA.
As an example, at retirement, assume you receive a distribution of employer stock worth $300,000 from your 401(k). Let’s also assume your cost basis in the stock is $75,000. The $225,000 gain is the NUA. When you receive a lump-sum distribution
that includes employer stock, you will pay ordinary income tax on the cost basis in the employer stock. You will not be responsible for tax on the NUA until you sell the stock. When that time comes, the NUA is taxed at long-term capital gains rates
regardless of how long you have held the stock outside of the plan. Any appreciation at the time of sale that exceeds your NUA will be taxed as either short-term or long-term capital gain, based on the holding period from the distribution date until
the subsequent sale.
Qualifying for lump-sum distribution
Typically, you are permitted to elect NUA treatment only if you receive the employer stock as part of a lump-sum distribution. In order to qualify as a lump-sum distribution, two conditions must be met:
- The distribution must be of your entire balance, within a single tax year, from all of your employer’s qualified plans of the same type.
- The distribution must be paid out after you attain the age of 59 ½, or as a result of your separation from service, or after your death.
If you wish to elect NUA treatment, make sure you don’t roll the employer stock into an IRA. If you do, keep in mind the transaction is irrevocable and you will forever lose the NUA opportunity.
On the other hand, stock held in an IRA or employer plan receives significant creditor protection which will be lost if the stock is held in a taxable brokerage account. Another consideration is that holding a large position of employer stock may not be appropriate for everyone. In many cases, diversifying the employer stock makes more sense.
In most circumstances, electing NUA treatment is most feasible for individuals who have a large amount of NUA along with a relatively low cost basis. However, the decision rests with many other factors such as your age, estate planning priorities, as well as anticipated future tax rates. In addition, you are not required to use the NUA strategy for all of your employer stock. In other words, you can roll a portion of stock into an IRA and apply NUA tax treatment to the remainder.
As always, consult with your tax advisor before implementing any financial strategy.
Janney Montgomery Scott LLC, its affiliates, and its employees are not in the business of providing tax, regulatory, accounting, or legal advice. These materials and any tax-related statements are not intended or written to be used, and cannot be used or relied upon, by any taxpayer for the purpose of avoiding tax penalties. Any such taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax advisor.