Net Unrealized Appreciation - Great Tax Benefit for Retirees

My financial advisor shared a great retirement tax strategy called Net Unrealized Appreciation or NUA. This strategy can be used to reduce the tax liability for employer stock in a company retirement plan.

Under the NUA strategy, employees take an in-kind distribution of company stock from their retirement plan (after leaving the company) and pay ordinary income taxes on the stock’s basis or original cost when it was put in the plan. The difference between the basis and the market value—the net unrealized appreciation—is taxed at long-term capital gains rates when the stock is sold, regardless of the holding period. This can be a significantly lower taxable event than rolling the stock into an IRA where all of its value will eventually be taxed as ordinary income.

Let's see how this would work for our hypothetical future retiree, Will B. Retired. Currently, Will has $1,000,000 in his company's retirement plan (ESOP, 401K, etc.). All of the savings, is in the form of his employer's stock, i.e. actual shares. These shares were purchased over the course of Will's employment. Will's company has done very well since the original cost of the stock in his retirement account was $50,000. Will has three choices when he retires from the company:

1. Leave the account with his employer. It would be continued to managed by his company and he would sell stock and take distributions as needed. The distribution would be taxed as ordinary income, i.e. as if it were salary.



2. Roll over the account to an IRA. Will can transfer the funds to an IRA, where they can be managed as he chooses. He can keep his company stock, or sell the stock to diversify his retirement portfolio. Distributions from an IRA would be taxed as ordinary income.



3. Do an in-kind transfer of the stock to a taxable account. In this case, Will would move the stock out of the retirement account into a taxable account. Assuming Will moved the entire account, he would only pay tax on the basis, or original cost, of $50,000. Tax would be paid on the balance, i.e. the Net Unrealized Appreciation, at the time the stock is sold. The tax rate would be at the then in effect long term capital gains tax rate.

Thus, by using the NUA approach, Will saves a significant amount of taxes since the maximum long term capital gains tax rate is 15%. In addition, the long term capital gains tax rate is lower than the ordinary tax rate at every tax bracket.

For reference, an NUA can be done after one of three triggering events: 1) the first distribution from the retirement account; 2) the first distribution after 59 1/2; and 3) death. To note, if the retiree is less than 59 1/2, he may owe a 10% penalty on the basis for early withdrawal.

For more details, see Revisiting Net Unrealized Appreciation: A Tax-Wise Strategy That May Realize More Benefits Than Ever in the Journal of Financial Planning. As with any personal financial strategy, please consult financial advisor and tax advisor before taking action.

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This is not financial or retirement advice. Please consult a professional advisor.

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