Net Unrealized Appreciation and Other Special Tax Rules

Investors in 401(k), ESOP, or other qualified retirement plans that allow investments in employer’s stock, need to know about net unrealized appreciation. The complex term – net unrealized appreciation is actually just a simple tax deferral opportunity with an unfortunately complicated name.

When a distribution from an employer’s retirement plan is received, the distribution is generally taxable at ordinary income tax rates. A common way of avoiding immediate taxation is to make a tax-free rollover to a traditional IRA. However, when ultimately receiving distributions from the IRA, the receivers will also be taxed at ordinary income tax rates. Special rules apply to Roth and other after-tax contributions that are generally tax free when distributed.

If the distribution includes employer stock (or other employer securities), there may be another option–deferring paying tax on the portion of the distribution that represents net unrealized appreciation (NUA). The investor will not be taxed on the NUA until stock is sold. Moreover, the NUA will be taxed at long-term capital gains rates–typically much lower than ordinary income tax rates. This strategy can often result in significant tax savings.

What is net unrealized appreciation?

A distribution of employer stock consists of two parts: (1) the cost basis (that is, the value of the stock when it was contributed to, or purchased by, an employee’s plan) and (2) any increase in value over the cost basis until the date the stock is distributed to the employee. This increase in value over basis, fixed at the time the stock is distributed in-kind to the investor, is the NUA.

For example, an employee retires and receives a distribution of employer stock worth $500,000 from his or her 401(k) plan; the cost basis in the stock is $50,000. The $450,000 gain is NUA.

How does the NUA tax strategy work?

At the time a lump-sum distribution that includes employer stock is received, the recipient only pays ordinary income tax on the cost basis in the employer securities. Tax on the NUA is not due until the securities are sold. And, at that time the NUA is taxed at long-term capital gain rates, no matter how long the securities have been held outside of the plan (even if only for a single day). Any appreciation at the time of sale in excess of the NUA is taxed as either short-term or long-term capital gain, depending on how long the stock outside the plan has been held.

Using the example in the chart above, an employee would pay ordinary income tax on $50,000, the cost basis, when the lump-sum distribution is received a 10% early distribution penalty can apply if the employee is not age 55 or disabled when the payment is received. For example, if the employee sells the stock after ten years, when it’s worth $750,000, at that time, long-term capital gains tax on the NUA ($450,000) along with long-term capital gains tax on the additional appreciation ($250,000), since the stock was held for more than one year, will apply. Note: since tax was already paid on the $50,000 cost basis, tax on that amount will not have to be paid again when the stock is sold.

If the distribution includes cash in addition to the stock, the cash can either be rolled over to an IRA or taken as a taxable distribution. And, the NUA strategy does not have to be used for all of the employer stock– it can be divided between an IRA rollover and the NUA tax treatment.

What is a lump-sum distribution?

In general, these favorable NUA tax rules are only allowable for employer securities received as part of a lump-sum distribution. To qualify as a lump-sum distribution, both of the following conditions must be satisfied:

• It must be a distribution of the entire balance, within a single tax year, from all of the employer’s qualified plans of the same type (that is, all pension plans, all profit-sharing plans, or all stock bonus plans)
• The distribution must be paid after age 59½, or as a result of separation from service (if employed), disability (if self-employed), or death

There is one exception: Even if the distribution doesn’t qualify as a lump-sum distribution, any securities distributed from the plan that were purchased with the after-tax contributions will be eligible for NUA tax treatment. After-tax contributions for this purpose do not include Roth 401(k) contributions.

NUA is for beneficiaries and heirs, too

If an employee dies with employer securities in a retirement plan, plan beneficiaries can also use the NUA tax strategy if they receive a lumpsum distribution from the plan. The taxation is generally the same as if the employee had received the distribution. The stock won’t receive a step-up in basis, even though the beneficiaries receive it as a result of the employee’s death.

If the employee already received the distribution of employer stock, elected NUA tax treatment, and dies before selling the stock, the heir(s) will have to pay long-term capital gains tax on the NUA when the stock is sold. However, any appreciation as of the date of the employee’s death in excess of NUA will forever escape taxation because, in this case, the stock will receive a step-up in basis.

Using the above example, if the employee dies when the employer stock is worth $750,000, the heir(s) will receive a step-up in basis for the $250,000 appreciation in excess of NUA at the time of the employee’s death. If the heir(s) later sell(s) the stock for $900,000, long-term capital gains tax on the $450,000 of NUA, as well as capital gains tax on any appreciation since the employee’s death ($150,000) will apply. The $250,000 of appreciation in excess of NUA as of the employee’s date of death will be tax free.

Some additional considerations

• Be certain NOT to roll stock over to an IRA to take advantage of NUA treatment,. That will be irrevocable, and the NUA tax opportunity will be lost.
• Employees can elect not to use the NUA option. In this case, the NUA will be subject to ordinary income tax (and a potential 10% early distribution penalty) at the time the employee receives the distribution, unless the distribution is rolled over to an IRA.
• Stock held in an IRA or employer plan is entitled to significant protection from creditors. That protection is lost if the stock is held in a taxable account.
• The impact of any applicable state tax laws should always be considered.

What are the advantages of NUA treatment?

• Distribution of NUA will be taxed at long-term capital gains rates, rather than ordinary income tax rates. Long-term capital gains rates are generally much more favorable, and currently are as low as 0% for some taxpayers.
• Distribution won’t be subject to the required minimum distribution rules that would apply to distributions rolled over to an IRA. The stock never needs to be sold.
• The NUA portion of distribution will never be subject to the 10% early distribution penalty tax.

What are the disadvantages of NUA treatment?

• The cost basis in the stock is subject to tax at ordinary income tax rates when the stock is distributed to the employee. A 10% early distribution penalty tax may also apply if the employee is not age 55 or disabled when the payment is received. (The 10% penalty tax generally doesn’t apply for the self employed.)
• The rollover IRA benefit of tax-deferred growth is lost.
• NUA treatment applies only to employer stock and other securities. But holding a significant amount of employer stock may not be appropriate for everyone. In some cases, it may make sense to diversify investments.

When is NUA treatment the best choice?

In general, the NUA strategy makes the most sense for individuals who have a large amount of NUA and a relatively small cost basis. However, whether it’s right depends on many variables, including age, estate planning goals, and anticipated tax rates. In some cases, rolling the distribution over to an IRA can be the better choice.

And, for those born before 1936, two other special tax rules (described below) might also apply to the lump-sum payment, potentially making a taxable distribution the best option.

What is the 10-year averaging method?

The 10-year averaging method is a special formula for calculating the federal income tax due on the ordinary income part of a lump-sum distribution from a qualified employer-sponsored retirement plan. This tax is paid only once—in the year in which the distribution is received; it’s not paid over the next 10 years.

Essentially, the tax is calculated on 1/10 of the taxable portion of the distribution, using 1986 income tax rates for single filers. It is then multiplied by 10 to determine the income tax due on the lump-sum distribution. Because the adjusted gross income (AGI) doesn’t include distributions calculated according to the 10-year averaging method, AGI-sensitive tax breaks won’t be adversely affected by the income from a lump-sum distribution.

What is the capital gain election for pre-1974 participation?

Capital gain treatment applies only to the taxable part of a lump-sum distribution resulting from participation in a qualified retirement plan before 1974. The amount treated as capital gain, reported on Form 1099-R, is taxed at 20%, which may be lower than the taxpayer’s ordinary marginal income tax rate.

If the capital gain election is made, the remainder of the taxable distribution (i.e., the portion representing participation from 1974 to the present) can either be treated as ordinary income, or the 10-year averaging method can be used for that portion.

What are the eligibility requirements for the 10-year averaging method and the special capital gains tax treatment?

To qualify for 10-year averaging and/or the special capital gains tax treatment, the following requirements apply to a lump-sum payment:

• The plan participant (whether alive or dead in the year of distribution) must have been born before 1936.
• The plan participant must have received the distribution after belonging to the plan for at least 5 tax years. Exception: the 5-year rule doesn’t apply if the distribution was paid because of the plan participant’s death.
• The plan participant (or the beneficiary) must elect to use the 10-year or capital gains tax treatment (and this election can generally be made only once).

The rules for 10-year averaging and the capital gains election are complicated, and other significant restrictions apply. Financial professionals can be of tremendous assistance with deciding which option (or combination of options) makes the most sense for each situation.