End of the year retirement plan distribution decisions are looming in the minds of many clients. For those clients who are eligible to take lump sum distributions from their qualified retirement plans, however, often overlooked considerations must be taken into account in order to take full advantage of the potential tax savings that can be realized if retirement plan assets include appreciated company stock.
In these cases, timing is everything—and it’s critical to realize that the window for taking advantage of the tax break that can be afforded to net unrealized appreciation may be closed for most clients who are considering the pros and cons of taking a lump sum distribution from a qualified retirement plan.
The Net Unrealized Appreciation Break
Clients whose qualified retirement plan assets contain appreciated employer securities may be eligible to take advantage of the net unrealized appreciation tax break. Net unrealized appreciation (NUA) is the gain on employer stock that has accrued from the time it was acquired within the qualified retirement plan up until the time that the stock is distributed from the client.
The NUA tax strategy allows certain clients whose qualified retirement plans contain these appreciated employer securities to pay taxes on the appreciated value of those securities at the lower long-term capital gains tax rate. The remaining qualified retirement plan assets are taxed at the taxpayer’s ordinary income tax rate under the traditional rule for taxation of plan distributions.
In order for a client to take advantage of the NUA strategy, he or she must be eligible to take a lump sum distribution from the qualified retirement plan in question. In order to be eligible for a lump-sum distribution, the client must have reached age 59½, become disabled or retired (for certain employees), or died. The eligible client transfers the funds in his or her tax-deferred account into a taxable account, realizing the gain on the sale of the employer securities.
This strategy has proven effective for some clients—for example, if employer securities within a client’s 401(k) are worth $100,000, but originally cost $20,000, only that $20,000 would be taxed at the client’s ordinary income tax rate. The remaining $80,000 would be taxed at the applicable long-term capital gains rate.
Potential Year-End Complications
While the NUA tax break can prove effective for clients who are eligible to take lump sum distributions from qualified retirement plans, year-end considerations can potentially complicate the strategy. This is because, while the client may be eligible to take a lump sum distribution from his or her qualified retirement plan, that distribution must occur within a single taxable year in order to qualify as a lump sum distribution.
If the client attempts to take a lump sum distribution late in the tax year, he or she may face unanticipated delays that could push a portion of the distribution into the next year should that distribution contain employer stock. Late in the tax year, there is obviously a greater possibility that a portion of the distribution could be pushed into the following tax year.
Unfortunately, if the entire account balance is not emptied by the end of the tax year, the client will not qualify for the favorable NUA tax break. As a result, this late in the year, most clients should be advised to delay the lump sum distribution into the next tax year in order to ensure that the distribution will take place within a single tax year in order to be taxed at the long-term capital gains rate.
The NUA tax break afforded to appreciated company stock held within a qualified retirement plan can be significant for many clients who hold highly appreciated employer stock—but because the simple misstep of failing to ensure that the entire account balance is distributed within a single tax year could cause the client to lose the entire break, proper planning is crucial to the NUA strategy.
Originally published on National Underwriter Advanced Markets. National Underwriter Advanced Markets is the premier resource for financial planners, wealth managers, and advanced markets professionals who provide clients with expert financial and retirement planning advice.
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