Spelling Out the Rules for the Net Unrealized Appreciation Tax Break

Are you a small business owner or corporate owner holding appreciated company stock in your 401(k) or other qualified employer-sponsored retirement plan? At some point, you may decide to cash in your stock. If so, you can benefit from an unprecedented federal income tax provision on the books.

Briefly stated, you can save tax if you take a lump-sum payout in company stock instead of converting the securities to cash first. Congress has threatened to crack down on this tax break for "net unrealized appreciation" (NUA) in the past, but it remains in place for now.

How It Works

When you receive distributions from a 401(k) or other qualified employer-sponsored plan, you're normally taxed at ordinary income rates, which currently reach up to 37%. Employees must generally begin taking required minimum distributions (RMDs) after age 73 (recently increased from age 72), or they may take payouts earlier if a "triggering event" occurs. The amount subject to tax includes the total value of the payout. (A 10% tax penalty applies to distributions taken before age 59½ unless an exception applies.) 

Suppose you contributed $300,000 to your 401(k) over the years and the contributions earned $700,000 inside your account without any tax erosion. Assuming the entire amount is paid out, you'd be taxed on a total of $1 million. If the full amount is taxable at the 37% rate, you'd owe $370,000 in federal income tax.

Similarly, you may have acquired company stock in your 401(k) account for $300,000. Say the stock is worth $1 million if you sell it prior to distribution from your account. When the $1 million is paid out, you're taxed on the entire amount, including the $700,000 in appreciation.

However, if you have company stock in your 401(k) plan or another qualified employer-sponsored retirement account, you can arrange to take an NUA distribution. In this case, your securities are shifted from your retirement account into a taxable brokerage account. You're still taxed on your "basis" in the stock (that is, your acquisition cost) at ordinary income tax rates. But the remainder—representing the appreciation in value of the stock—is taxable as long-term capital gain. Plus, you benefit from tax deferral.

Under current law, long-term capital gain is generally taxed at a 15% rate as opposed to the top 37% rate on ordinary income. For certain high-income retirement-savers, the maximum tax rate on long-term capital gains is 20%. That's still a good deal—a 17% rate differential from ordinary income tax rates.

Let's go back to our previous example where you acquired company stock in your 401(k) account for $300,000, and it's currently worth $1 million. Again, we'll assume that you're in the top 37% tax bracket for ordinary income.

If you use the NUA strategy, only the initial $300,000 acquisition cost would be taxed at the 37% ordinary income tax rate, incurring a federal income tax obligation of $111,000 ($300,000 times 37%). But the $700,000 of appreciation would be taxed at the maximum 20% capital gains rate instead of 37%. Your federal capital gains tax obligation would be $140,000 ($700,000 times 20%). Due to the 17% rate differential, you'd save $119,000 ($700,000 times 17%).

In addition, retirement plan payouts don't count as net investment income (NII) for purposes of the 3.8% NII tax. This tax applies to the lesser of NII or modified adjusted gross income (MAGI) above $200,000 for single filers and $250,000 for joint filers. Minimizing your MAGI also reduces exposure for this extra tax. 

Other Important Issues

The NUA tax break isn't automatic. To qualify for this tax-favored treatment, the following conditions must be met:

• You participate in a qualified employer-sponsored retirement account, such as a 401(k) plan.
• The account holds securities issued by the employer.
• The account is on a pretax basis (a Roth-type account doesn't qualify).
• You're a current or former employee of the company.

Note that this situation commonly occurs when a business owner or manager owns company stock in a 401(k). But it may also apply to, say, corporate bonds in a pension plan. Conversely, you can't qualify for the NUA break for securities held in a traditional or Roth IRA or a nonqualified deferred compensation arrangement.

Furthermore, consider the following four key requirements:

1. A distribution must be made only for a valid triggering event. In other words, you can't simply take the securities out of your account. The distribution must be due to one of the following situations:

• The employee's death,
• The employee reaching age 59½, or
• The employee separating from service (for example, due to retirement, termination or resignation).

2. All the securities must be transferred in a lump-sum distribution in one tax year. You can't parcel out shares of stock over time. And you can't undo the transfer once it's completed. To avoid current tax on the non-NUA portion of a 401(k) payout, you can roll over those funds into a traditional IRA, the 401(k) or another qualified employer-sponsored plan. 
3. NUA securities must be transferred from the qualified employer-sponsored retirement plan into a taxable brokerage account. You won't qualify for NUA if they're moved to a traditional IRA or a 401(k) of another employer. So, if you get a new job, you can't benefit from NUA and keep the tax deferral going.
4. You must pay the IRS on the distribution of securities. When you receive the distribution, remember that you still owe ordinary income tax on the portion of the transfer representing your basis.

However, you don't have to pay any tax on the appreciation in value of the securities until you sell the stock. At that point, the gain is treated as a tax-favored long-term capital gain. The tax on any subsequent appreciation depends on the holding period. A short-term gain is taxable as ordinary income. 

A payout of NUA can count as a required minimum distribution, but the timing and sequencing of payments can be tricky. The portion of the non-NUA securities must be transferred to an IRA before the NUA portion is transferred to the brokerage account.   

Moral of the Story

This is just the basics of this complex tax strategy. It requires careful planning so don't wait too long and don't go it alone. A misstep along the way can cost you tens or even hundreds of thousands of tax dollars. Your SSB tax advisor can provide the necessary guidance for you to navigate the rules.

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