Silver Linings – NUA Tax Break in a Down Stock Market

by Prof. Robert Bloink and Prof. William H. Byrnes

The recent turbulence in the stock market has created stress across-the-board. In response, many investors have weighed selling—even at a loss—as stock prices wobble up and down in a veritable roller-coaster-like scenario. While market downturns rarely bring anything positive for ordinary investors, those who own employer stock in their retirement plans may have an opportunity to reduce their eventual tax liability with the net unrealized appreciation (NUA) strategy. Because a low tax basis in the employer stock actually 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

NUA is the gain on employer stock that has accrued from the time it was acquired within the client’s 401(k) plan up until the time that the stock is distributed to the client. In other words, NUA is the growth of the stock value over and above what the client originally paid for it (their tax “basis”), which can often be substantial in cases where a client’s employer provided a discount to employees purchasing company stock years ago.

If the client’s 401(k) holds employer stock that has appreciated over the years, 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 percent 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.

In order for a client to take advantage of the NUA strategy, they must be eligible to take a lump sum distribution from the 401(k) plan in question. This means that the entire value of the account (and all accounts sponsored by the same employer) must be distributed (whether to a taxable account or IRA) within one single tax year, though all distributions need not occur at the same time. This is why it becomes important for the client to begin evaluating the potential NUA strategy fairly early in the tax year.

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 capital gain on the sale of the employer securities when those securities are sold, while the remaining assets can be transferred into an IRA.

Importantly, the employer stock must be segregated from the other 401(k) assets—meaning that the client cannot simply roll all assets into an IRA. Once the employer stock is rolled into an IRA, the potential NUA tax break will be lost.

NUA Tax Strategy in a Volatile Market

Obviously, taxpayers 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 (though the client is permitted to apply the NUA strategy to only a portion of the securities received in the lump sum distribution).

A client who liquidates their employer stock in a down market can immediately repurchase their shares at the reduced rate. The employer’s basis in the stock will then be set at that reduced rate going forward. Assuming the employer stock eventually rebounds once we exit this turbulent period, the NUA distribution in the future becomes more valuable given the lower basis point.

The client must pay close attention to the price of their employer stock. 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 their cost basis in the stock.

Conclusion

Market volatility is rarely pleasant for average American investors. Still, when opportunities arise, clients should understand the potential silver linings. While the NUA tax planning strategy is relevant only to a select group of clients who own employer stock, depressed stock prices can add significant value when it comes to increasing future tax savings.