For many clients who have reached age 70½, it’s the time of year when end-of-year retirement plan distribution decisions have become imminent—but it’s not too soon for many younger clients to also begin considering which strategies will be most beneficial with respect to their future required minimum distributions (RMDs). 

Several strategies can be employed far in advance in order to reduce the potential future tax burden that RMDs can generate, and for clients whose retirement plans contain appreciated employer stock, these planning decisions are especially important. If the client satisfies certain specific requirements, he or she may benefit from an often-overlooked net unrealized appreciation (NUA) strategy that can generate substantial tax savings over time.

The NUA Strategy Basics

Clients whose employer-sponsored 401(k) plan assets consist partially of appreciated employer securities may be eligible to take advantage of the NUA tax planning strategy. NUA is essentially 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 to the client (i.e., the fair market value at distribution minus the original stock basis).

(Related: Working Past 70½? Skip the 401(k) RMD Without Penalty)

The NUA tax strategy allows certain clients whose qualified retirement plans contain these appreciated employer securities to eventually 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 rules for taxing 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. This means that the entire value of the account (and all similar accounts sponsored by the same employer) must be distributed (whether to a taxable account or IRA) within one single tax year, though multiple distributions may be made to different accounts.

The employer securities are taken as shares in the company, and cannot be converted into cash prior to distribution. 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 employer securities held in his or her 401(k) into a taxable account, realizing the gain on the sale of the employer securities when those securities are sold, while the remaining assets can be transferred into an IRA or Roth IRA, depending upon whether they consist of pre-tax or after-tax contributions.  Importantly, the client must be careful to capture all employer contributions that were made to the account throughout the year, keeping in mind that some contributions may be made in the following year.

The Fine Print

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 (lower) long-term capital gains rate.

It’s also important to look to the client’s age to determine the value of the NUA strategy—if the assets would remain within the receiving IRA for a substantial period of time after transfer, they will theoretically have time to appreciate significantly in value. This potential post-distribution appreciation can be more valuable to some clients, particularly those who are relatively young and not yet subject to RMDs.

Clients who are retiring but have not yet reached age 59 ½ (so that the early withdrawal penalty would continue to apply if he or she transferred the assets to an IRA) may benefit from the NUA strategy by transferring the shares into a taxable account and gaining access to the proceeds of the shares once they are actually sold.

The client should also pay attention to the potential long-term growth potential of the shares—the NUA strategy is most valuable with respect to employer stock that has appreciated—or has the potential to appreciate—substantially.

Conclusion

The NUA strategy won’t work for every client, but for clients with substantial employer stock held within their 401(k)s, it can provide a substantial tax break—and understanding this often-overlooked strategy can allow an advisor to add significant value to the client relationship.

For previous coverage of RMD planning in Advisor’s Journal.

For in-depth analysis of distributions from retirement plans, see Advisor’s Main Library.

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