Individual investors commonly believe that an IRA rollover is their best option for continuing to defer taxes on qualified plan assets when they leave their employer. If the account includes employer stock, however, treating the stock differently from other plan assets may be an attractive alternative.
Many individuals who have worked for their employers for several years accumulate significant holdings in their company’s stock within their qualified plans. When an employee owns company stock in a qualified plan that has appreciated in value, the stock may be eligible for special tax treatment under the net unrealized appreciation (NUA) rule.
What is NUA?
NUA allows individuals to take a distribution of employer stock from their qualified plan and pay ordinary income tax (and potentially the 10% early withdrawal penalty) only on their basis at the time of the distribution, allowing for continued deferral on the balance of the stock’s value. The difference between the basis and the fair market value at distribution–the net unrealized appreciation–is taxed at capital gains rates when the stock is eventually sold. This special income tax treatment is referred to as net unrealized appreciation in Internal Revenue Code Section 402(e)(4).
Under the NUA strategy, the individual is withdrawing the employer stock from the retirement plan, not rolling the shares over to an IRA. The NUA rule does not apply to stock held in an IRA; in fact, rolling the stock over to an IRA will nullify the NUA treatment. If the shares are distributed from the IRA, they will be subject to ordinary income tax rates. The different tax liabilities involved in withdrawing the shares as opposed to rolling them over to an IRA is the determining factor in the NUA strategy.
What are the requirements for NUA?
To qualify for NUA treatment, the distribution of plan assets must generally be a lump sum distribution. The NUA rule ceases to apply once a participant takes partial distributions or distributes plan assets over more than one tax year.
The employee must elect a lump sum distribution from the plan of all plan assets within the same calendar year. A lump sum distribution is defined as a “distribution or payment within one taxable year of the recipient of the balance to the credit of an employee which becomes payable to the recipient, on account of the employee’s death, after the employee attains age 59 1/2 , on account of the employee’s separation from service, or after the employee has become disabled.” In other words, the lump sum distribution must include all assets, not just the shares of employer stock. In addition, the NUA rule does not apply if the stock is liquidated in the plan and distributed as cash.
While all plan assets must be distributed within the same tax year, the participant can elect to have a portion of the distribution rolled over and a portion withdrawn for the purpose of electing NUA treatment. For example, a participant could roll over his or her qualified mutual fund assets to an IRA and distribute the company stock. Another option is to roll over some of the company stock to an IRA and use the NUA treatment on the balance. Keep in mind, however, that NUA treatment will be lost on any shares that are rolled over to an IRA.
Individuals who plan to use the NUA strategy must notify their plan administrator in advance to obtain the documentation required and to ensure that the 20% mandatory withholding is based only on the cost basis, not on the entire distribution. The administrator reports the amount withheld on the basis to the IRS.
Who would benefit from NUA?
The NUA rule is most beneficial for people who have large amounts of highly appreciated company stock in qualified plans. For individuals who have an immediate or short-term liquidity need, the NUA strategy can provide a significant source of assets (the employer securities) to generate the needed funds. Given that only the basis is subject to ordinary income taxes, the total taxes on the distribution are likely to be less than if the entire distribution were subject to ordinary income tax rates.
NUA treatment may also be advantageous for participants who separate from service at an early age. The 10% premature distribution penalty applies to qualified plans for employees who separate prior to age 55. When employer securities are distributed, in accordance with the NUA requirements, the additional 10% tax penalty applies only to the original cost basis, not the full value of the distribution. This strategy may provide an opportunity to minimize the tax implications of a premature distribution.
The NUA strategy is also available to beneficiaries of employer stock held in a qualified plan that has not been distributed before death. The step-up in basis, which usually occurs at death, is not available for the portion of the value of the stock that is NUA, because NUA is considered income in respect of a decedent (IRD). However, the heirs can still use the capital gain rates for the embedded NUA when shares are sold.
As with other highly appreciated assets, employer stock distributed from a qualified plan may also be an appropriate asset to use for a charitable remainder trust. In this way, an individual could use the income tax deduction for a charitable contribution to offset the taxes due on the basis upon distribution. Furthermore, when the stock is sold by the trust, the NUA will be characterized as long-term gains in the four-tier accounting system.
When to use the NUA strategy
When determining whether to use the NUA strategy for employer stock, it is important to consider how the client plans to use the assets in the future. Individuals who do not plan to use the assets for their retirement but wish to leave them to their children or grandchildren may want to roll those assets over to an IRA, which would allow them to “stretch” the account for the benefit of the IRA beneficiaries.
Several factors should be considered when determining whether or not the NUA strategy would be appropriate for your client. Consider the following:
? The cost basis and current value of the employer stock.
? The timeframe for when the assets will be needed.
? Potential penalties that may be incurred for a premature distribution.
? Your client’s effective tax rate.
? Any estate planning considerations your client may have.
NUA can help meet your clients’ individual planning needs in any number of ways. Working with a qualified tax professional familiar with NUA can ensure that this tax strategy is used effectively. Sharing the NUA strategy with corporate executives or human resource professionals could prove to be a tremendous resource for potential clients and referrals.
John Koehler is a director for the Retirement & Wealth Strategies Group at Jackson National Life Distributors LLC. Jackson National Life Distributors LLC, headquartered in Denver, Colorado, is the sales and marketing arm of Jackson National Life Insurance Company, Lansing, Mich. Mr. Koehler can be reached at firstname.lastname@example.org.