A prospective retiree can distribute appreciated employer stock from his 401(k) and in the process reduces her tax burden from high ordinary income tax rates, which are presently 37%, to preferential long-term capital gain (LTCG) rates: 0%, 15%, 20%, while avoiding the net investment income tax (NIIT), presently 3.8%. She can do this using a little-known and misunderstood tax strategy known as net unrealized appreciation (NUA), which is the difference between the purchase price and fair market value (FMV) of employer stock held in a retirement plan, such as a 401(k).
NUA is not widely known or understood because the IRS has published very little about it outside Treasury Regulations. Further, NUA is not often discussed because it has limited ap- plicability and time constraints for eligibility.
A client is nearing retirement and has contacted her advisor to discuss the tax implications of an NUA. She brings a copy of her most recent quar- terly statement from her 401(k) account. The client intends to retire on June 7, 2019. The statement shows:
• A total account value of $1,475,126.
• Holdings in Company stock, which is traded publicly, of $500,000.
• Basis of the Company stock is $50,000, which includes employer contributions of $30,000 and employee contributions of $20,000.
• Holdings in several mutual funds of $975,126. The client says that she has heard of NUA from her stockbroker, but does not understand it.
She wants her advisor to explain how it could benefit her and how it works.
The advisor could begin by explaining that an NUA would involve a lump-sum distribution of company stock from the client’s tax-deferred 401(k) account to a taxable account.
The client would instruct her custodian to make a lump-sum distribution of her Company stock to a taxable stock brokerage account, in the amount of $500,000. The balance of her account, $975,126, which consisted of mutual funds, would be rolled over to her IRA account. The rollover IRA would be from custodian to custodian and, thus, not taxable. After the lump-sum distribution, she would have a rollover IRA account valued at $975,126 and an individual brokerage account valued at $500,000, which holds company stock.
The custodian of the 401(k) account would issue a 1099-R (Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.) to the client for the tax year of the lump-sum distribution. The form would have a taxable amount in box 2a of $50,000, representing the adjusted basis of the stock, and an NUA amount in box 6 of $450,000. The taxable amount would generally be included in income on Form 1040 as taxable IRAs, pensions, and annuities. The client may also be subject to an early withdrawal tax of 10% on the adjusted basis of the stock as well, unless an exception applies.
Assuming a 2018 marginal income tax rate of 37% for 2018, the client might be subject to income tax of 37% × $50,000 = $11,100, but would not be subject to the NIIT of 3.8%. However, the Company stock held in the client’s individual brokerage account would have a basis of $50,000, a deemed long-term holding period, and an FMV of $500,000. If the stock was sold the day following the lump-sum distribution, the client would be subject to income tax on the difference be- tween the basis and the FMV at preferential LTCG rates. Assuming a rate of 20%, the client would be subject to capital gains taxes of 20% × $450,000 = $90,000.
Contrast that example with one in which the client did not make a lump-sum distribu- tion of NUA stock. When she uses the NUA, she pays $11,100 of federal income tax and $90,000 of LTCG taxes, which totals $101,100. Her effective tax rate is $101,100/$500,000 = 20.2%. If the client did not use the NUA, and sold the Company stock during the same time-frame, she would have been subject to income tax of $500,000 × 37% = $185,000. Using the NUA, she saved $83,900.
This is not a typical scenario. The purpose of the example was to show an estimated calculation. Many clients often take retirement distributions over many years and can defer required minimum distributions until the year that they reach age 70 & 1/2. As a result, clients usually pay lower ordinary income tax rates in future years. They might also be able to avoid capital gains taxes altogether if they exchange their stock within their IRA or 401(k). Accordingly, a central consideration is whether the client should actually use an NUA.
When to Consider NUA
To consider whether the client should use NUA, a tax advisor should consider the client’s expected income in retirement. Many retirees have income from permanent sources such as the So- cial Security Administration (SSA), pensions, and annuities.
Example. Client expects to receive $36,000 from SSA, $65,000 from a pension, and $24,000 from an annuity for total income of $125,000. Social Security income is not always taxable, but for pur- poses of this analysis, assume that it is fully taxable. If the taxpayer is single without dependents, her total income less standard deduction is $125,000 – $12,000 = $113,000. Using the 2018 tax com- putation worksheet, $113,000 × 24% = 27,120 minus $5,710.50 = $21,409.50 income tax. Her effective rate is 17%.
If the client uses an NUA, an additional $200,000 would be included in her income of the year of the lump-sum distribution. There- fore, her income would be $125,000 plus $50,000 = $175,000. Subtracting the standard deduction ($12,000), her taxable income would be $163,000. The increase in taxable in- come pushes her from a marginal income tax rate of 24% to 32%. Using the 2018 tax compu- tation worksheet, $163,000 × 32% = $52,160 minus $18,310.50 = $33,849.50 income tax. Her effective rate is 19.3% and she pays $12,440 more of tax ($33,849.50 over $21,409.50).
As the client sells her Company stock from her taxable stock brokerage account, she is sub- ject to 15% LTCG tax. Therefore, the FMV of $500,000 less the basis of $50,000 = $450,000 gain and the capital gains tax is $67,500. That amount plus the additional income tax paid in the year of the distribution of $12,440 equals $79,940 and her effective tax rate on the NUA stock is 16%.
That rate should be compared to the rate that she would pay had she not used the NUA and made a required minimum distribution from her retirement account. In that case, her marginal tax rate would be 24% up to $157,500 of taxable income, and then 32% for income in excess of $157,500. If she withdraws $25,000/ year, the distribution will be taxed at 24%. However, she would pay an average rate of 16%, and, therefore, save approximately 8%, if she used the NUA. There may be other consid- erations, such as time value of money, invest- ment considerations, the client’s ability to pay the tax after the NUA, and the client’s interest in the transaction. Nevertheless, based on the analysis above, the client could benefit from the NUA as a tax-savings device.
The IRS considers the NUA as a part of a lump- sum distribution from a qualified retirement plan or a qualified retirement annuity (see Section 402(e)(4), which codifies the NUA). The prototypical case involves the following:
1. A person who is on the verge of retirement, or is in the tax year following the tax year of re- tirement.
2. The retiree has invested in company stock within his 401(k) retirement account.
3. The company stock has appreciated suffi- ciently to warrant consideration of the NUA transaction.
4. Theretireeisotherwiseeligibleforarolloverof the 401(k) to an IRA account.
Mechanics. Section 402(e)(4) makes the NUA in employer securities in a lump-sum distribution not includable in income. The taxpayer would owe income tax on the employer and employee contributions and can elect to include these amounts in income. Pursuant to Section 402(e) (4)(D), a lump-sum distribution must be made by the close of the tax year following the year that the balance becomes payable to the recipient. Section 402(e)(4)(D) defines payable to the recipient as (1) on account of the employee’s death; (2) after the employee attains age 591/2; (3) on account of the employee’s separation from service; or (4) after the employee has become disabled.
Pursuant to Notice 98-24, 1998-1 CB 929, the NUA will be deemed LTCG even if the actual holding period is shorter. For example, stock acquired less than a year before the NUA is deemed long-term on distribution. Therefore, in the example above, the entire balance of $500,000 is treated as LTCG even if the stock was acquired in the months prior to the distri- bution. However, subsequent appreciation of the company stock after the lump-sum distribution is treated as short-term capital gain. Thus, if the Company stock appreciated to $501,000, the $1,000 gain would be treated as short-term capital gain until held for more than a year.
The client cannot have made another distri- bution from the 401(k) within the tax year of the lump-sum distribution. There may be a limit in the number of rollovers that the client can make, although direct rollovers are not limited. Also, the existence of a 401(k) loan may affect the transaction. The Company stock must be distributed in kind. Pursuant to Reg. 1.1411-8, the NIIT does not apply to the distri- bution. Further, if making an NUA for a dece- dent, the NUA stock would not be subject to a step-up in basis pursuant to Rev. Rul. 75-125, 1975-1 CB 254. However, this provision is con- fusing as to whether the company stock would receive a basis step-up on the client’s subse- quent death. For planning purposes, additional consideration should be made to determine the applicability of a step-up in basis.
By rolling the Company stock into an traditional brokerage account, the client continues to defer tax on the NUA of the stock. If the NUA transac- tion is used, future dividends from Company stock are paid to the brokerage account and taxed at preferential qualified dividend tax rates of zero, 15%, or 20%. If the NUA is not used and the Com- pany stock is rolled over into an IRA, dividends paid on the Company stock would not be taxed on receipt. Rather, the client pays ordinary in- come tax on making a distribution from the IRA.
Special Consideration for Investment Professionals
While the NUA transaction can provide a poten- tial source of tax savings to the client, stockbro- kers and financial advisors may discourage its use because they believe that carrying a highly appre- ciated and highly concentrated individual stock holding is contrary to the rule of prudency of di- versification. Investment professionals generally manage their client’s risk by diversifying away from concentrated holdings in a portfolio. Pru- dent diversification standards within the industry hold that no individual security should make up more than 5% of a client’s portfolio holdings.
When a client completes an NUA transac- tion, the company stock is held as a concen- trated position in a taxable account and the po- sition cannot be diversified without triggering a capital gains tax event. Unless the client has expressed an interest in the transaction, most investment professionals would prefer to roll over the stock into an IRA account. On the share being received in the IRA account, the stock would be sold within the IRA account, which would keep the realized appreciation on
the sale of the stock deferred until the retiree takes periodic distributions of income.
Once the stock is sold within the IRA, the investment professional could diversify freely into a portfolio of assets that would be appro- priate for the retiree’s long-term goals and needs. Therefore, it is advisable to not let the tax tail wag the dog. It is important to weigh the benefit of the tax savings against the benefit and protection of diversification and asset allo- cation, particularly for a retiree living on a fixed income. By contrast, if a retiree proceeds with the NUA transaction, there are a variety of hedging strategies that the investment profes- sional might use to protect the retiree’s stock position from an adverse decline in the value.
Cost Basis Election
A cost basis election could be made as a planning consideration for the client, who could elect to contribute after-tax dollars to her 401(k) in antic-ipation of the NUA transaction. This would allow her to use after-tax dollars to reduce the cost basis of the Company stock. In essence, the client would fund her 401(k) periodically while employed using salary deferrals to reduce her cost of the Company stock. The 401(k) custodian would use the after-tax salary deferral to reduce the cost basis of the Company stock. If the after- tax dollars reduce basis to zero, when the NUA transaction is consummated, the Company stock would be distributed with a zero cost basis and its value would be considered entirely NUA, and tax-deferred. Consequently, no tax would be due on the NUA.
NUA can be a highly effective tax savings oppor- tunity. With the planning assistance of a practi- tioner, the client can determine his or her eligibil- ity, ascertain the potential tax savings, and execute the transaction with confidence.
CHARLES J. ZIMMERER, Esq., CPA, is a tax attorney and CPA in Miami. His website is cjzfirm.com. ALEXANDER S. TECLE, B.S., MBA, M. Tax, of Anthem Advisors, contributed to the article.
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Originally Published in November 2018 Volume 101 Number 5 Practical Tax Strategies.