Navigating the Net Unrealized Appreciation Tax Strategy

As an advisor, part of your value proposition is educating your clients on financial planning strategies that they may be unfamiliar with but that could benefit their long-term financial picture. Occasionally, some of these strategies may also be foreign to you! One prime example is the net unrealized appreciation tax strategy (also known as NUA).

Here, I’ll break down how the NUA strategy works; how your clients will be taxed; and, using a case study, how you might implement this strategy for your clients.

By definition, NUA is the difference in value between the average cost basis of shares and the current market value of the shares held in a tax-deferred account. It presents a planning opportunity for your clients when used as part of an NUA tax strategy.

The NUA strategy is available to qualified plan participants who own their company’s stock inside their qualified plan. When your client takes a lump-sum distribution from his or her qualified account, he or she may elect to move the NUA-eligible stock (which can be some or all of the employer stock) to a nonqualified account and receive special tax treatment, while rolling the remainder of the assets to a rollover IRA. The client’s basis in the company stock will immediately be taxed at ordinary income levels, but any growth will be taxed at the lower capital gains rate.

The ultimate goal of an NUA election is to limit the ordinary income taxation on the stock. If the client were to roll the shares into an IRA instead, the value of the shares would be fully taxable as ordinary income when the client eventually sells them and makes a distribution. Therefore, the client needs to weigh the value of forgoing tax-deferred growth versus minimizing the ordinary income taxation.

As with most financial plans that involve limiting your client's tax exposure, there are strict guidelines that must be followed when implementing the NUA strategy: 

• The client must have a qualifying event:
  • If the client is not self-employed, this would be reaching age 59½, separation from service, or death.
  • If the client is self-employed, this would be reaching age 59½, disability, or death.
• The entire balance of all employer-sponsored qualified plans, including pension and stock plans, must be distributed within the same tax year.
• The client must be at least 59½, unless an exception applies (e.g., terminating employment after reaching age 55).

Here, it’s important to note that the above requirements address the basics of NUA eligibility. Encourage your clients to consult with a tax advisor when contemplating this strategy, as there are additional complexities to the rules that are beyond the scope of this post.

The client’s tax on NUA stock can be broken into three components: 

1. Basis in the employer stock. The client’s basis in the employer stock is immediately taxable as ordinary income in the year of the distribution.
2. Gain in the employer stock at the time of NUA distribution. Any accumulated gain in the stock will be given permanent long-term capital gain (LTCG) status, regardless of when the shares were acquired in the employer-sponsored plan and regardless of when the shares are sold.
3. Any additional gain (or loss) when the shares are sold later. If the shares are sold after the initial NUA distribution, any gain or loss accumulated from the time of the distribution to the time of the sale will be treated as a long- or a short-term capital gain (STCG) or loss, depending on the length of the holding period since the NUA distribution.

Let’s look at an example to help illustrate everything we’ve discussed thus far.

Cassidy Client retired from Super Corp. in 2010 at the age of 65. She had accumulated 1,000 shares of Super Corp. stock in her 401(k) plan. The shares all had a basis of $25.

When Cassidy fully distributed her 401(k), she elected NUA treatment by moving the 1,000 Super Corp. shares to her taxable brokerage account. The remainder of her 401(k) was rolled over into her IRA. On the date that Cassidy distributed the Super Corp. shares from her 401(k), the fair market value (FMV) of the stock was $50 per share. 

• The $25 of cost basis was immediately taxable as ordinary income, so Cassidy paid $25,000 ($25 basis × 1,000 shares) in the tax year of the distribution.
• The $25 of gain on the shares at the time of the distribution will be permanently treated as LTCG.

Nine months after Cassidy’s NUA distribution, the FMV of Super Corp. is $100 per share, and Cassidy sells 500 shares for total proceeds of $50,000. 

• Cassidy was already taxed on her cost basis of $25 per share, so $12,500 is nontaxable at the time of the sale.
• The initial $25 of gain on the shares that she had at the time of the distribution is still taxed as LTCG, so she had $12,500 in LTCG ($25 LTCG × 500 shares).
• The additional $50 in gain that has accumulated since Cassidy distributed her NUA stock was treated as STCG because the shares were held for only 9 months after the NUA distribution, so she had $25,000 in STCG ($50 STCG × 500 shares).

After another nine months (i.e., a year and a half from Cassidy’s original NUA election), the FMV of Super Corp. is $125 per share, and Cassidy sells the remaining 500 shares for total proceeds of $62,500. 

• Again, Cassidy was already taxed on her cost basis of $25 per share, so $12,500 is nontaxable at the time of the sale.
• The initial $25 of gain on the shares that she had at the time of the distribution is still taxed as LTCG, so she had $12,500 in LTCG ($25 LTCG × 500 shares).
• The additional $75 of gain that had accumulated since Cassidy distributed her NUA stock was treated as LTCG because the shares were held for more than a year after the NUA distribution, so Cassidy had $37,500 in LTCG ($75 LTCG × 500 shares).

Over the time that Cassidy held the shares, here’s a breakdown of what she paid: 

• $25,000 in ordinary income tax (in the year of the NUA election)
• $12,500 in STCG (at the time the shares were sold)
• $50,000 in LTCG (at the time the shares were sold)

Assuming a 25-percent marginal income tax rate and a 15-percent capital gains tax rate, Cassidy would have paid the following:

• Approximately $9,375 ([$25,000 in basis + $12,500 in STCG] × 25 percent) in ordinary income tax
• Approximately $7,500 ($50,000 in LTCG gains × 15 percent) in capital gains tax
• $16,875 in total taxes

What if, instead, Cassidy had rolled these shares into an IRA and then sold the shares and distributed the proceeds in the same way she did above? She would have paid: 

• $12,500 ([500 shares × $100 per share] × 25 percent) in ordinary income tax on her first distribution
• $15,625 ([500 shares × $125 per share] × 25 percent) in ordinary income on her second distribution
• $28,125 in total taxes

As such, using the NUA strategy, Cassidy saved $11,500 in taxes.

Of course, there are several factors to consider before implementing this strategy. Generally speaking, those clients who have highly appreciated employer securities with a low cost basis may benefit from the NUA strategy. And the higher the income tax bracket, the greater the benefit.

If your client has a particularly high tax year, however, he or she may not be willing to take on the additional income tax burden of an NUA strategy. Likewise, if the client does not have available cash to pay for the income tax, NUA may not be an option. Further, it may not be ideal when a client has a high basis in his or her employer stock or if the value of the stock has fallen below the client’s basis. Finally, the client may have other planning needs to consider (e.g., bankruptcy protection) that weigh in favor of moving the assets to an IRA rather than to a taxable account.

Bottom line? While this strategy may be appropriate for many clients, it is important to look at the client’s full tax picture when making the decision to elect NUA.

Have you successfully used the NUA strategy with your clients? Do you have an effective method for explaining this option? Please share your thoughts with us below!