In today’s economy, it seems the average time spent working for a company is five to seven years before moving on to the next challenge. Although it may surprise you, there are still many people who have worked at the same company for several decades. For these individuals, as part of their retirement plan, investing in their employer’s stock through their 401(k) is fairly common. In fact, according to research at the University of Chicago, over 11 million Americans take a concentrated stock position in their retirement accounts. This means that 20% or more of their retirement account is invested in their employer’s stock.

For these savers, the investment in company stock can pay off dramatically over time.  This significant appreciation in price may be eligible for special tax treatment under the NUA rule, depending on how the stock is distributed.

What is NUA?

Currently, federal tax laws contain a little-known rule that apply to certain transfers of company stock from the employee’s retirement plan.  Only the cost basis of the stock (what the person paid for the stock) is taxable upon distribution/transfer.  The difference of the market value of these shares, minus the cost basis is the Net Unrealized Appreciation or NUA.  The NUA is not taxable until the shares are sold, and are never subject to early-withdrawal penalties.  This is particularly beneficial to early retirees, who need to access retirement income prior to age 59 ½, in order to avoid early withdrawal penalties. (10% plus income taxes)

Currently, workers resigning from their company or retiring have four options for their retirement savings:

• Keep the stock in their employer’s plan

• Transfer the stock to an IRA, using a tax-free rollover

• Take the entire amount as a withdrawal

• Transfer a portion to their IRA and take the remainder as a lump-sum distribution

The most common choice by individuals is to rollover the entire balance of the 401(k) to an IRA, tax-free.  This seems like the most sensible decision, since the entire balance will not (immediately) be subject to taxation.  However, if your 401(k) includes company stock, a rollover of the entire amount may do more harm than good.

Is NUA for me?

The first step is to determine the cost basis.  Your company’s human resources department can help with this, or the investment firm that manages the savings plan can assist as well.  The cost basis is the price paid over a period of time to acquire the shares of stock.  This is important because it will determine how much ordinary income tax the participant would be responsible for, if choosing NUA.  Knowing the cost basis will also help determine what the capital gains tax would be once the company stock is sold.

To make things clear, we will illustrate two scenarios.  One will cover the traditional rollover option and the second will speak to the NUA option.  Suppose the employee in question has worked for a company for many years, and is close to retirement.  Assume they have accumulated 5,000 shares of stock in a 401(k) plan and the stock is trading at $80 per share.  As a result, the total market value of the stock is $400,000.  If the cost basis in purchasing these 5,000 shares is $20 per share, your total NUA would be $60 per share, or $300,000.

Scenario One:

If you were to liquidate the shares of stock and withdraw the amount in cash or rollover the entire balance of the 401(k) and take distributions from an IRA, taxes would be based on the ordinary income tax rate.  Assuming this is 35%, the total tax would be $140,000.

Scenario Two:

If you were to transfer the entire amount of shares in-kind, the NUA rule would apply and the total tax would be calculated as follows.  The cost basis would be taxed as ordinary income 35% on the $100,000 paid to acquire the stock.  ($20 per share, times 5,000 shares).  The tax would be $35,000.  The remainder ($60 per share) would be taxed at 15%, equal to $45,000.  Total tax paid in this scenario, $80,000.

The opportunity to use the NUA strategy commonly occurs close to or at retirement.  You are only given one chance to use the feature.  If you rollover without NUA, you lose the capability to use NUA in the future.  Therefore, we want to be sure you are properly equipped to make an informed choice.  We have only begun to outline the strategy in this article.  If you would like further details or an analysis of your personal situation, please contact your Wealth Manager.  

References: Putnam, Merrill Lynch, University of Chicago

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