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Do you own company stock with gains in your 401(k) or ESOP plan? If you do, it is vital that you understand a lesser known strategy of distributing that stock when you leave your job. The lower tax brackets we have until 2025 can make this strategy even more appealing.
Normally a distribution from a retirement plan is ordinary income. However, an exception is provided for a qualifying lump sum distribution of employer stock that has net unrealized appreciation or NUA. NUA is defined as the fair market value of the stock distributed over the cost basis of the stock contributed to the plan at the date of contribution.
Certain requirements must be met in order for the distribution to be a qualifying distribution. First, it must be a distribution of the entire account within a one year period. Nothing can be left in the plan after the distribution or any other qualified plan. Second, it must be after a triggering event, which is 1) reaching age 59 1/2, 2) separation from service, 3) death or 4) disability. Third, it must be an in-kind distribution of employer stock. The stock itself must be distributed.
The portion of the distribution that is considered NUA (the gains you have) is not taxed upon distribution and will only be taxed when the stock is ultimately sold. When the stock is sold, the amount of NUA will be treated as long-term capital gain rather than ordinary income. Any subsequent appreciation in the stock will result in capital gain, either long-term or short-term depending on how long the stock is held after distribution.
If you have highly appreciated employer stock in a retirement plan, you can distribute all the stock to a brokerage account and pay ordinary income taxes on the low cost basis and not the total value of the stock.
Here is how it works. Jill receives a lump sum distribution of stock from her employer’s qualified plan valued at $500,000. The value of the stock at the date of contribution to the plan was $100,000. $400,000 will be treated as NUA and not taxed at the date of distribution. Jill will have $100,000 taxed as ordinary income in the year of distribution. This strategy works best when Jill is retired or has a low income in the year of distribution.
Because Jill paid tax on the $100,000, her tax basis in the shares will be $100,000. Assume 2 years after the distribution, the value of the stock has increased to $700,000 and Jill sells her stock. The $400,000 of NUA and the subsequent appreciation of $200,000 will be taxed as long-term capital gain. Had Jill sold the stock prior to holding it for a year, the NUA portion would have been taxed as long-term capital gain and the gains that occurred after the distribution would be taxed as short-term capital gain.
To give you an understanding of how valuable this strategy can be, let’s make Jill’s case extremely favorable. If Jill were to pull out her company stock using the NUA strategy in 2018 when she and her husband had no other income, the first $24,000 would come out tax free, and some would be taxed at the 10% and 12% brackets. Jill and her husband would have a total tax bill of only $8,742 on the withdrawal of $500,000 in stock from her 401(k) plan.
Related: How One Financial Planner Saves for Retirement
I will assume that Jill and her husband have sufficient savings to live on that first year and don’t have to trigger any other taxable income. In the next tax year, Jill decides to diversify her portfolio and sell shares that have a $100,000 long term capital gain. If that is their only income for that tax year, they will end up paying zero in capital gains taxes on those gains because their income is low enough. Jill could recognize about $100,000 of gains each year for the first few years of retirement
It should be noted that there are several issues to be considered in whether this strategy makes sense for you, such as paying tax today versus paying tax in the future. The cost basis of the stock is important in the analysis. If the total amount in the employer plan were rolled over into an IRA, there would be no tax due in the year of distribution versus the amount of the cost basis of the stock being reported as ordinary income. If the stock price is close to what your cost basis is, this strategy usually doesn’t make sense.
There is the opportunity to cherry pick the stock that you want to distribute versus distributing all of it. If your plan’s custodian can specifically identify the stock and there is stock that was contributed to the plan with a very low basis and other stock that has a high cost basis, you can distribute just the low cost basis stock and transfer the high basis stock to an IRA. Thus, only the low cost basis would be recorded as ordinary income currently.
While the entire account balance must be liquidated, there is no requirement that the entire balance be taken in a taxable transaction. Just the NUA portion of the account can be taken as an in-kind distribution and the remaining balance can be rolled over into an IRA.
If the amount of employer stock is a significant percentage of the retirement portfolio, a sale of stock may be necessary in order to get the portfolio diversified. The investment risk and return of the portfolio needs to be considered, not just the tax implications.
Assuming you want to take advantage of the NUA strategy, the stock will be transferred into a taxable brokerage account. Once the stock is sold, all the earnings on the proceeds from the sale will be taxable going forward, versus if the earnings were growing tax-deferred in an IRA. So an analysis of the taxes paid today, both at the ordinary and long-term gains rates will need to performed to see if you come out better by transferring the entire account to an IRA where the stock can be sold and all the tax deferred until distributions are taken from the IRA.
Your age at the date of distribution also matters. If you are close to taking RMDs from your IRA, the tax deferral of the IRA is less important. If you are under age 59 and a half, there will be a 10% penalty on the distribution of the stock.
It is important to note that when you sell your stock in your retirement plan, it resets the cost basis and could potentially ruin your ability to take advantage of the NUA strategy. This strategy works best when you have big gains in the stock. If you sell it and buy it back, you replace the old low-cost basis with the new cost basis. And finally don’t let the tax tail wag the investment dog. I am sure there were some Enron employees close to retirement that had huge gains who were looking to take advantage of NUA and saw the stock in their 401(k) go to zero.
It is your choice whether or not to elect NUA treatment; it is not a requirement. This is one of the more complex decisions to make in retirement planning. There are a lot of rules and issues that can’t be covered in a short article. We can help you analyze the tax consequences and long-term impact of electing NUA treatment versus transferring the account to an IRA and letting the balance grow tax-deferred.