NUA Net Unrealized Appreciation

January 20, 2017

NUA… No, it’s not a medical condition. It is net unrealized appreciation and if you are aware, it could save you thousands of dollars in tax liability. So…. I am in my office doing the seemingly never ending hours of continuing education. I get this

email at 2:18 pm. Its urgent…. From a client’s financial advisor who I had emailed three days prior wanting to discuss this matter. She says “We are here and need to make a decision by 2:30”. I wonder sometimes why it is human nature to wait until the last possible moment to make decisions and act on what could have been done days ago, … But… She needs to determine how much to elect to distribute from our mutual client’s retirement account and elect to be treated as “NUA”.

I will not bore you with the details of what the precise requirements are to qualify and the precise rules surrounding this transaction. This is not my purpose here. I will attempt to explain what this is and why it should be important to anyone retiring with stock of the company for which they work in their retirement account. My purpose is to arm you with the proper information and not provide individual tax advice. You should seek the individualized advice from YOUR advisors. If you do not have advisors, now is a good time to seek competent advice.

So… NUA… It’s not a difficult concept. It simply refers to the amount that your company stock, inside your retirement account, has grown in value over what you paid for it. So, you work for a large corporation for many years. You contribute to the company retirement plan. A portion of your contributions are used to buy company stock within that plan. Simple right…? The stock hopefully grows in value over the years and is worth some amount more than what you paid for it. Great! This is how it’s supposed to work. So, she tells me he has all this company stock that he only paid an average of $16 per share and now its worth $84. Good, I think. Then the truth comes out. There are more shares which he paid $60 per share and more at $70 per share. So…. What to do and why does this matter? Let’s step back and talk about how you would be taxed if this were you.

If you retire from your company as this individual did and simply rolled all your retirement funds into an IRA with an investment firm, like most people do, when you eventually take this money out it would be subject to “ordinary” income tax rates. See, there are different tax rates for different types of income. Proceeds from an IRA are usually ordinary income. Ok, keyboard commandos, I said “usually”. There are always exceptions, hence my disclaimer that this information does not constitute individual advice. If you elect to separate your company stock into an account which is not your IRA, you only pay tax on the cost of that stock and you pay capital gains tax on the gain later when you decide to sell it. So, for the sake of argument, let’s assume that this individual had only one investment in his retirement account and it was all company stock worth $300,000. He only paid $75,000 for this stock over the years. The additional $225,000 represents gain. So, let’s look at a couple of examples:

Example 1 – He does what many do, retires and moves his money into an IRA with an investment firm and takes all the money out over his retirement years. We will simply use three years for purpose of this example. The concept will hold true with any amount of years.

Year Amount Withdrawn Ordinary Income Tax
1 100,000 25,000
2 100,000 25,000
3 100,000 25,000
Total 300,000 75,000

In the above example, he simply pays tax on his distributions at his ordinary rate of 25%. Now let’s assume he is aware of this nice aspect of the tax code and he elects to take the NUA election and distribution at retirement and elects all his company stock (which for our example is all his account value) as an NUA election. So, what happens… Well, with this election you pay ordinary income tax on your COST basis in the stock when you take it out. Anything above that cost basis is taxed as capital gains at the applicable capital gains rate when you liquidate it. Wait! This can’t be good, can it? Let’s see.

Example 2 He elects to treat his company stock as an NUA distribution.

Year Amount Withdrawn Ordinary Tax Capital Gains Tax
At retirement 0 (It is only put in his new account, nothing liquidated. 18,750

His tax is based on his cost basis (75,000 x25%)

0
1 100,000 0 11,250

(100,000-25,000) * 15% (capital gains rate)

2 100,000 0 11,250
3 100,000 0 11,250
Total 18,750 33,750

In the above example, he now has 75,000 in cost basis which is proportionately applied to his distributions 1/3, 1/3 and 1/3 since his distributions are 1/3, 1/3 and 1/3. This cost reduces the amount of gain recognized by 25,000(75,000/3) each year. So, with this election he pays $52,500. A savings of $22,500. I don’t know about you but that is a lot of money. Again, this is a simplified explanation. Your situation will be different and there are many variables. Seek Advice!

In the most basic of examples let’s assume the same facts except he takes all the money out the week after he retires. Here are the tax implications with and without electing NUA:

Without electing NUA: $300,000 Distribution at ordinary tax rate of 25% would create a tax liability of $75,000

Electing NUA: Tax at election on cost basis of $75,000 @ 25% equals tax liability of $18,750 plus the gain of 225,000 taxed at capital gain rate of 15% creates a tax liability of $33,750 for a total liability of $52,500. Same result.

Now… back to my specific client. How much! That was their question. The simple answer is no one can tell you with certainty. There are simply too many variables involved. I could go on with examples where for the right client in the lower income tax bracket after retiring, I could structure this transaction where no capital gains taxes would be paid. Remember, for individuals in the lowest income brackets, the long-term capital gains rate is 0% Yes…. Nothing! So, these potential savings could be far greater. There are also considerations about leaving the money to continue to grow tax deferred and paying zero tax now. Again, each situation is different. In my client’s example, we elected NUA on the lowest cost portions of his stock. Those shares which he only had a $16 cost. As a rule of thumb, the greater the gain in the stock is, the more it makes sense to follow this option. Also, the same holds true for your tax rate. The greater your ordinary effective tax rate is, the more sense this makes.

I hope this information was useful and as always, I welcome comments and feedback on topics which are of interest to you. Please subscribe to receive notification when I post another article.

Chris

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