According to a report from the Fidelity Research Institute, millions of Americans may be able to lower their tax bills when it is time to take distributions from their company retirement plans. Net unrealized appreciation (NUA), a special tax treatment for the distribution of company stock, could save millions of American taxpayers significant tax dollars over their lifetime. The report concludes that although this could be one of the most valuable strategies available to retiring employees, it is also one of the most underused tax rules. This is due to the complexity of the tax rules.
NUA occurs when an employer allows an employee to purchase and hold company stock in a qualified plan, such as a 401(k), and there is appreciation in the stock above the purchase price. When the employee leaves the company or retires, this rule allows the employee to receive the company stock—and only the company stock—from his 401(k). The employee will pay ordinary income tax only on the cost basis of the shares, not the fully appreciated market value of the stock. The appreciation is taxed later at the long-term capital gains tax rate when the stock is eventually sold. Currently, the long-term capital gains rate maxes out at 15%, versus a possible higher income tax rate that could be as high as 35%. Any other assets held in the 401(k) plan must be rolled over into an IRA to avoid ordinary income taxes.
If the situation warrants and the election is handled properly, the obvious benefit is a much lower tax burden for the employee in the first year and possibly greater tax savings in the future. Traditionally, most retiring employees roll their 401(k) assets into an IRA rollover account at retirement. Most financial advisors view this as the only option. However, assets held in an IRA or left in a 401(k) plan will, after age 70½, be subject to a required minimum distribution. Currently, assets withdrawn in this manner would be subject to ordinary income tax rates.
There are many considerations to work through before an employee will know if this is the right strategy for their unique situation. First, would the employee be subject to early withdrawal penalties? NUA does not bypass the typical early withdrawal rules. Second, the trustee of the 401(k) plan must allow for this type of distribution. Many plans do not have this as an option on the “cookie cutter” distribution request form. Additionally, a thorough tax analysis may be helpful to determine what the tax liability would be today and how it compares to estimated future tax costs. An employee should also consider if some of the stock will need to be sold to pay for the tax on the transfer.
NUA election can be most helpful to individuals who have much of their wealth concentrated in employer stock, and have a great deal of appreciation in that stock. However, there can also be drawbacks to this type of distribution. This is a complicated strategy where many mistakes are made when not handled correctly. Before pursuing this option, it is important to plan ahead and seek advice from a qualified tax adviser. For more information, please contact Henssler Financial at 770-429-9166, or experts@henssler.com.