By: Richard Feldman CFP®, AIF®, MBA
If you have employer stock in your retirement account rolling it over to an IRA could be the worst financial mistake you ever make. An obscure tax rule regarding employer securities (Employer Stock) held in a corporate retirement plan could possibly save you a vast amount in taxes. Even though the tax break has been around for sixty years, individuals fail to take advantage of it due to lack of knowledge and complexity of the rules surrounding it. This article will address the tax minimization opportunities of NUA (Net Unrealized Appreciation) for individuals holding employer stock inside their corporate retirement plan.
Net Unrealized Appreciation
This term refers to the appreciation in the value of employer stock held in a qualified retirement plan from the time the stock was originally placed in the participant’s qualified plan account to the time of distribution of the stock. The central issue in dealing with NUA is the special tax advantages afforded employer stock that is subject to NUA. The Internal Revenue Code favorably treats NUA in certain situations, deferring taxation of the appreciation until the employer stock is actually sold [Sec. 402 (e) (4), I.R.C.]. To follow are some common terms regarding Net Unrealized Appreciation.
1) Average Cost Basis: Represents what your company’s 401(k) or other retirement plan paid for your shares. This component is taxed at ordinary income tax rates when the shares are distributed from the plan. The ultimate amount of tax paid on the basis depends on your Adjusted Gross Income in the year of distribution.
2) Net Unrealized Appreciation: Is the difference between average cost basis and the stock’s fair market value when the company shares are distributed. This component is always taxed at long term capital gains rates at the time of sale, unless you specifically elect to pay the tax at the time of distribution.
3)Additional Appreciation: Is the difference between the fair market value of your company shares at the time of distribution and the price you receive when you dispose of the shares. The additional appreciation will be taxed as short-term or long-term capital gains depending on how long you hold the shares after they are distributed to you from the plan.
Only employer contributions and pre-tax employee contributions are eligible for this net unrealized appreciation tax strategy, and only if they are distributed as a lump-sum distribution. A distribution will qualify as a lump-sum distribution if it is due to:
- Attainment of age 59 ½
- Separation from service
The retirement account must be fully distributed of all plan assets in a single calendar year. Make sure that there is no balance left in your retirement plan when using this strategy or the NUA tax strategy may be disqualified. If so, you could possibly owe taxes on the fair market value of the stock distributed which could be disastrous. Another important consideration is that there will be a 10% penalty imposed if the individual has not reached the age of 55.
Suppose, for example, that Jim Smith has accumulated employer stock in his retirement account. The shares in the plan were valued at $100,000 when acquired by the plan meaning that they have a tax basis of $100,000. The shares have grown in value to a million dollars. If Jim retires and withdraws those shares he’ll owe taxes on the basis of those shares ($100,000) at ordinary income tax rates. In this example, the Net Unrealized Appreciation (NUA) is $900,000. If Jim subsequently sells the shares outside of the retirement plan, he will be taxed at the current 5% or 15% long-term capital gains rates depending on his tax bracket.
An approach which most individuals are familiar with is a rollover of the retirement plan to an Individual Retirement Account (IRA). This approach would involve selling all the securities in the retirement plan and rolling over the proceeds to an IRA. This method allows the individual to defer the taxation on the retirement funds since no income taxes will be due and payable until such time as distributions are made from the IRA. Required minimum distributions start at age 70 ½ and if your IRA is large enough, these required distributions, which are taxed as ordinary income, could push you into the highest tax bracket (currently 35%). In addition, if you reside in a state that has a state income tax the state tax would be imposed in addition to the 35% federal rate.
The ultimate benefit to a high tax bracket individual is having the proceeds qualify for long-term capital gain rates rather than ordinary income tax rates. If you retain all the shares held in your corporate retirement plan and roll them over to an IRA all the appreciation of the employer stock will be turned into ordinary income upon withdrawal which could have a tax rate of almost 20% higher than long-term capital gains rates. The highest marginal tax rate in 2011 would be 39.6% and capital gains would revert to 20% from 15% if the Bust tax cuts expire.
If you distribute the stock and continue to hold the securities once they were rolled out of the retirement plan the dividends on the employer stock will be taxed at 15% dividend rates in 2010 rather than ordinary income tax rates if the dividends were paid inside an IRA. Dividend taxation under the Bush tax cuts are also set to expire and dividends would then be taxed at ordinary income tax rates in 2011.
Employer stock that has been distributed from an employer plan will receive a step up in basis at death for the individual’s beneficiaries and heirs. The step up in basis is only on the appreciation of the stock once it has been distributed. NUA is not eligible for a step up in basis to your heirs. They would pay capital gains on the difference between fair market value and the cost basis when the stock was distributed.
A significant portion of an individual’s total net worth could theoretically be tied up in one stock. This greatly increases the total risk of a portfolio and every effort should be made to reduce this company specific risk. There are many options that an individual has to reduce this company specific risk.
Sell the whole block: An individual can sell the whole block of stock and take the proceeds and buy a diversified portfolio of equities, bonds, and REITs.
Gifting: Individuals may gift up to $13,000 worth of cash and securities each year and avoid gift taxes. If a married couple has a child who will be attending college, they could gift the child $26,000 of the securities per year to help pay for college. If the child were in the lowest tax bracket, the capital gains rate on the eventual sale of the stock would only be 5%.
Charitable Remainder Trust: Another strategy would be to gift the shares to a CRT. The CRT can sell the shares without owing any tax because it is a charitable trust. A diversified portfolio could then be designed to provide an income stream to the individual.
Exchange Fund: These funds are private partnerships formed by Wall Street firms. Each individual partner contributes appreciated stock to the partnership assets, which become diversified based on the equity contributions of the partners. After a few years, exchange funds terminate according to the partnership agreement. They generally distribute their assets to each partner pro rata meaning that the individual will end up with a portion of each stock that was contributed to the partnership.
Options and Collars: Wall Street firms have designed techniques to limit the downside on concentrated equity positions if an individual is willing to limit his upside potential.
The existence of substantial NUA in an individual’s retirement plan provides significant tax planning opportunities. Retirees with cash flow problems could find an immediate cure by choosing this tax strategy. An analysis of the individual’s circumstance would have to be undertaken in order to conclude whether they would be better served by taking a distribution of NUA stock and paying ordinary income on the cost basis of those shares or deferring taxation by selling or keeping the shares and rolling over the proceeds to an IRA. Typically the distribution of the employer stock should yield a much higher after tax return rather than rolling the shares over to an IRA. Once the shares have been distributed to a taxable account they may be used to satisfy your cash flow needs. The problem with this technique is that not many people are aware of this option until after the transaction has already been completed.
If you are contemplating this technique, please contact your tax advisor in order to do a thorough analysis of the entire transaction including alternative minimum tax consequences. In addition, you should also consult a financial advisor to explore which technique is most appropriate to reduce the concentration issues associated with holding employer stock.