The recent turbulence in the stock market has created stress across the board. In response, many investors have weighed selling — at a loss — as stock prices wobble in a veritable roller-coaster-like scenario.
While market volatility is rarely pleasant for average American investors, clients should understand the potential silver linings when opportunities arise. Those who own employer stock in their retirement plans may have an opportunity to reduce their eventual tax liability with the net unrealized appreciation strategy.
Because a low tax basis in the employer stock increases the value of the NUA tax break, depressed prices offer a significant planning opportunity for clients who own company stock — if the strategy is executed in a tax-smart manner with a focus on long-term tax savings.
NUA Tax Strategy: Basic Mechanics
Net unrealized appreciation is the gain on employer stock that has accrued from the time it was acquired within a client’s 401(k) plan until it is distributed. NUA, then, is the growth of the stock value above what the client originally paid for it — the tax basis — and it can often be substantial in cases where an employer provided a discount to workers purchasing company stock.
If a client’s 401(k) holds employer stock that has appreciated, the client may be eligible for long-term capital gains tax treatment when the stock is sold, rather than the ordinary income tax treatment that would typically apply to traditional 401(k) distributions.
Further, the 3.8% net investment income tax that is often added to the long-term capital gains rate for higher-income clients is not applied to the NUA, which is treated as a qualified plan distribution.
To take advantage of the NUA strategy, clients must be eligible to take a lump-sum distribution from the 401(k) plan in question. The entire value of the account (and all accounts sponsored by the same employer) must be distributed, whether to a taxable account or individual retirement account, within a single tax year.
Even though all distributions need not occur at the same time, it’s important for clients to begin evaluating the potential NUA strategy early in the tax year.
To be eligible for a lump-sum distribution, the client must have reached age 59.5, become disabled or retired (for certain employees), or died.
The eligible client transfers the employer securities held in a 401(k) into a taxable account, realizing the capital gain on the sale of those securities when they are sold. The remaining assets can be transferred into an IRA.
The employer stock must be segregated from the other 401(k) assets — so the client cannot simply roll all assets into an IRA. Once employer stock is rolled into an IRA, the potential NUA tax break will be lost.
NUA Tax Strategy in a Volatile Market
Taxpayers, of course, pay taxes on any gain when they liquidate stock. If the basis of the stock is high compared to the amount by which the stock has appreciated, the NUA strategy may be less valuable.
A client who liquidates employer stock in a down market can immediately repurchase the shares at the reduced rate. The employer’s basis in the stock will then be set at that reduced rate going forward. Assuming that the employer stock eventually rebounds, the future NUA distribution becomes more valuable given the lower basis point.
When markets are turbulent, it’s natural for investors to want to play it safe. Waiting until conditions improve could actually harm a client’s position when it comes to the NUA tax rules. That’s because it’s entirely possible that the employer’s stock could rebound quickly, before the client has the chance to repurchase it at a reduced value and, thus, reducing the cost basis in the stock.
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