Exploring the Benefits of Net Unrealized Appreciation
October 13, 2017
It is not unusual here in Silicon Valley for employers to offer their employees the opportunity to acquire company stock as an investment alternative in their 401(k) plans. Employees may acquire equity shares using pre-tax dollars, or even better, at no cost when shares are granted as a matching contribution. But eventually, whether because of retirement or job change, you will need to decide how to deal with those assets. Consider the advantages of using the Net Unrealized Appreciation tax strategy (NUA).
The Internal Revenue Code has a provision relating to treatment of NUA. It allows you to take advantage of potentially much lower tax rates on the appreciation of company stock held in your 401(k). Instead of rolling these shares into another retirement account, you can transfer them into a personal account. If you follow this path, you pay ordinary income tax only on the original cost of the stock. The NUA is the difference between the value of the stock on date of transfer minus the basis. When (and if) you sell these shares, you pay long term capital gains tax on this amount. Any additional appreciation (gain that occurs after you transferred stock into taxable account up to sale date) is taxed at short-term capital gains rates if held less than one year after transfer. Other assets in your 401(k) do not receive NUA tax treatment so they will be rolled in to an IRA, where they will continue to benefit from deferred tax on past and future growth.
To qualify, you must:
Distribute the entire vested balance in all qualified plans with your employer within one tax year;
Take the company stock distribution as shares, not cash; and,
Experience one of the following triggering event:
Reach age 59 ½;
Separate from service from company whose plan holds the stock;
Qualify as eligible for total disability; or
At your death
Pros:
Long term capital gains tax rates apply to NUA as of the distribution date regardless of subsequent holding period. Therefore, you can diversify out of company-specific risk without holding shares for a full year.
If the stock is rolled over into an IRA rather than distributed out of a taxable account and you need cash, distributions from IRA are subject to your ordinary income tax rate. If this rate is higher than the long term capital gains tax rate, it makes sense to place these shares in a brokerage account.
The 3.8% Medicare surtax on net investment income does not apply to NUA of employer securities distributed from an employer plan. It will apply to any additional capital gains incurred since you transferred the shares into your personal account when the shares are sold.
Assets in your taxable account are not subject to Required Minimum Distribution rules or early withdrawal penalties that apply to IRAs. You control when you pay income taxes on the NUA portion.
Utilizing the NUA treatment reduces the value of your IRA, which will then reduce Required Minimum Distributions at age 70 ½.
Upon your death, beneficiaries do not receive a step up in basis on NUA. However, any appreciation from distribution date to date of death does qualify for a step up in basis. Beneficiaries also inherit your tax treatment so, instead of the ordinary income tax rate on IRA distributions, your beneficiaries will enjoy the preferred long term capital gains tax rate as they receive the funds.
If you are charitably inclined, you further manage your tax obligations by using these shares to contribute directly to charity or through a charitable remainder trust, foundation or donor-advised fund. This is a topic best discussed with your wealth and tax advisor if it is of interest to you.
Cons:
If your portfolio is heavily concentrated in stocks, your risk of loss may outweigh the potential tax savings.
You lose your ability to diversify out of the company stock without paying capital gains taxes.
Assets held in an IRA are entitled to significant protection from creditors. The loss of protection on stock held in your taxable account should be considered.
If you hold stock distributed from your plan and the price falls dramatically, you may have paid tax up front for shares of stock that are worth less.
Keep in mind, you have the option to split the shares of stock so that you can use NUA treatment on low cost shares and transfer the others to your IRA. Knowing the exact basis for your stock is key, so contact your company or 401(k) administrator to confirm this information; and be sure to include your wealth advisor and tax preparer in the conversation when mapping out the best course of action for these shares, given the complexities associated with these decisions.
Disclosure:
Sand Hill Global Advisors (“SHGA”) is a registered investment adviser with the Securities and Exchange Commission however, such registration does not imply a certain level of skill or training and no inference to the contrary should be made. SHGA may only transact business in the states where the firm is noticed filed or otherwise exempt. For disclosures, including additional information on credential designations of SHGA representatives please see our Form ADV Part 2A and 2B Disclosure Brochures, which can be obtained by clicking here. SHGA is separately owned and unaffiliated with any other firm or entities mentioned or featured in this video. This video presentation may discuss certain investment products and/or securities and is being provided for informational purposes only, and should not be considered, and is not, investment, financial planning, tax or legal advice; nor is it a recommendation to buy or sell any securities. Investing in securities involves varying degrees of risk, and there can be no assurance that any specific investment will be profitable or suitable for a particular client’s financial situation or risk tolerance. Past performance is not a guarantee of future returns. Individual performance results will vary. The opinions expressed in the video reflect SHGA’s views as of the date of the video. Such views are subject to change at any point without notice. You should not treat any opinion expressed by SHGA as a specific inducement to make a particular investment or follow a particular strategy, but only as an expression of general opinion. Nothing presented herein is or is intended to constitute investment advice, and no investment decision should be made based solely on any information provided on this video. There is a risk of loss from an investment in securities, including the risk of loss of principal. SHGA does not guarantee any specific outcome or profit. Any forward-looking statements or forecasts contained in the video are based on assumptions and actual results may vary from any such statements or forecasts. SHGA encourages you to consult with a professional financial advisor prior to making any investment decision.
