Checking All the Boxes with Net Unrealized Appreciation

By Jeremy T. Rodriguez, JD
IRA Analyst
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Net Unrealized Appreciation (“NUA”) is a powerful tool that people with employer stock in company plans should be aware of. Under this tax concept, the gains on the employer stock that are distributed according to the NUA rules are subject to long term capital gains rates when sold. That could be a huge tax break for some people. Normally, distributions from a company plan are subject to ordinary income tax rates, which while dependent on income are generally going to be higher than long-term capital gains rates.

Of course, there’s a catch: the basis in that stock is taxed at ordinary income tax rates in the year of the distribution. Because of this, the first step in any NUA analysis is to determine whether the company stock is highly appreciated enough to justify accelerating the taxes. Think about it this way, when an employer contributes company stock to an employee’s account, the value of that stock in the contribution year is the basis. The future appreciation is the NUA. Therefore, if the appreciation in the stock isn’t great enough, you may want to consider simply rolling over the entire account and delaying the income taxes. However, if you decide to use NUA, here are some things you must keep in mind:

1. In-kind Distribution – The stock must be distributed in-kind. It cannot be cashed out within the plan or the shares rolled over to an IRA. Either action eliminates NUA treatment. Basically, we are talking about the participant receiving the share certificates. However, the IRS has approved simultaneous elections where the participant elects to receive the shares in-kind but then immediately sells them back to the plan. This is common with Employee Stock Ownership Plans (“ESOPs”).

2. Lump Sum Distribution – This means the entire account must be emptied by the end of the plan year in order to qualify for NUA treatment. The rule applies to both NUA and non-NUA assets within your company plan account. For example, if a plan account had (i) employee contributions which were invested in mutual funds, (ii) an employer match which was also allocated to mutual funds, and (iii) company stock, all assets in the account must be distributed by the deadline. If not, NUA treatment is lost.

3. Triggering Event – The distribution mentioned above made after a triggering event. The distribution doesn’t have to occur immediately after a triggering event occurs. However, once a triggering event does occur, the first distribution following the event is looked at for NUA treatment. The triggering events are:

• Age 59 ½ (Plan may not allow a distribution)
• Disability (self-employed only)
• Separation from Service (not for self-employed)
• Death

4. Multiple Plans (Aggregation Rules) – If your company has more than one plan that you participate in, you will want to be careful. When looking at the lump sum distribution rule mentioned above, the IRS requires you to aggregate all “like” plans. That means both plan accounts need to be distributed for NUA treatment to apply. These rules are complicated, but a good rule of thumb is that if one of the plans is a 401(k) plan that you contribute to, and another is a defined benefit plan which pays an annuity, they are not aggregated.

5. Rolling Over Non-NUA Assets – Now a bit of good news. Remember the lump sum distribution rule? While those non-NUA assets must be distributed from the plan, they do not have to be taken into income. That means you can roll those assets over to an IRA or other qualified plan.

6. Basis Calculation – This will turn on how the plan tracks basis. For example, if the plan could use an “acquisition date method,” meaning it tracks the basis separately for each share contributed to your account. That means you could potentially “cherry pick” which stock certificates are distributed, choosing the older certificates with the greater appreciation and rolling over the newer contributions. Unfortunately, not all plans use this method or allow “cherry picking.” Some use an “aggregate method,” meaning your basis is determined by combining the basis of each contribution.

The tax benefits of NUA treatment are obvious to anyone that reviews the ordinary income tax rates and the long-term capital gains rates. That remains true even under the new tax reform rates. However, knowing the rules is crucial. A mistake is generally fatal, and the IRS rarely grants relief for NUA errors. In fact, in an infamous Private Letter Ruling, the IRS denied relief to people who were misled by their own plan representatives! Therefore, if you are considering NUA, talk to a well-qualified advisor before taking any action.