Net Unrealized Appreciation: Right for Your Clients?

If some of a client’s 401(k) balance consists of shares of their employer’s stock, an adviser may want to consider another distribution option for these shares net unrealized appreciation.
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One of the key areas in which clients look to their financial advisers for guidance is what to do with their 401(k) when leaving an employer. In many cases the right answer is either to roll this money into an IRA, roll the money to the plan of a new employer if applicable or in some cases to leave the funds in their old employer’s plan.

If some of the client’s 401(k) balance consists of shares of their employer’s stock, you may want to consider another distribution option for these shares, called net unrealized appreciation or NUA. This technique, which is part of the tax code, allows investors the opportunity to take distribution of these company shares to a taxable account and to pay income taxes on the cost basis of the shares versus the current market value.

The rest of the account that is not invested in company stock can still be rolled over to an IRA to preserve the tax-deferred nature of these assets. As the shares may have been accumulated at various periods over a number of years, your client will need to get this cost basis information from their company’s plan administrator.

Account Distribution

Jim Blankenship, on his blog FinancialDucksInARow.com, points out that one of the stipulations in the NUA rules says that the entire value of the retirement account must be distributed within the same calendar year. He says, “If you don't complete the entire distribution of the account within a single tax year, NUA treatment is no longer available. The key here is that none of your 401(k) plan money can still be in the account at the end of the tax year. Everything, including your NUA stock and all non-NUA monies, must be removed within that single tax year.”

This precludes leaving some of the money in the old employer’s plan while distributing stock to a taxable account to take advantage of the NUA treatment. If a full distribution of the account isn’t made and the shares were distributed to a taxable account, tax would then be due on the stock’s market value and not the cost basis.

In-Kind Distribution: The shares must be distributed in-kind to the taxable account, it is not permissible under the NUA rules to distribute the value in cash.

Triggering Event: NUA can be used only in conjunction with a triggering event, including

  • Separation from service
  • Death or disability of the account holder
  • Reaching age 59½

The ability to do an in-service withdrawal would not be a triggering event on its own but would be in conjunction with reaching age 59½.

Deciding if NUA Is the Right Approach

David Smith of Robinson Smith Wealth Advisors says, “NUA can make a lot of sense if the cost basis on the stock is very low compared to the current price.” This is because if the low basis stock is held for at least a year after the distribution under the NUA rules, any gain on the sale will be taxed at preferable long-term capital gains rates. This could result in substantial tax savings compared to ultimately paying taxes on the value of the shares at ordinary income tax rates.

Smith adds, “For investors with a high percentage of their investment assets in retirement accounts, NUA can help them diversify some of their holdings into taxable accounts.” This is important for a number of reasons. Beyond the opportunity to pay taxes on the sale of the stock at lower capital gains rates, this tax diversification can serve as a hedge against the uncertainty of future tax rates.

NUA won’t always be the right approach when a client leaving an employer has company stock in their retirement plan. Smith cautions, “NUA may not make much sense if the difference between the cost basis and value of the stock is small or if the investor may take a sizable tax hit on the transaction.” This is the type of planning opportunity where you can show your value as your client’s adviser.

Note that if NUA is to be used, it doesn’t need to be used on all of the shares of company stock. The shares to be given the NUA treat can be cherry-picked in order to accomplish whatever you and your client are trying to do in terms of managing capital gains and cost basis for the shares distributed. The rest of the shares could be rolled over to an IRA if desired as part of the full account distribution.

One other planning consideration, according to Blankenship concerns estate planning. He says, “Upon the death of the original owner, if there is stock that has been given NUA treatment, this stock does not step-up in value when inherited. The beneficiary (or the estate) receives the same basis that the original owner of the NUA-treated stock had after the original distribution. This can surprise heirs sometimes, because there is still a capital gain to be taxed upon the sale of the NUA-treated stock.”

NUA can serve as another planning tool in advising clients regarding their 401(k) when they leave their employer. This tool can add a degree of flexibility to your planning options for these clients.