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The Tax Benefits of Net Unrealized Appreciation

When you get a new job or start working for a company, your pay and benefits can take different forms. Your salary is often your primary form of taxable income, but companies can compensate you in other ways with benefits packages, perks, retirement plans, 401(k)s, and even shares of the company. tax benefits of net unrealized appreciation

One of the ways that companies and organizations can compensate their team is by giving them equity in the company, via employee stock ownership plan (ESOPs) or profit-sharing. If you do in fact have stock within your company 401(k) you could potentially be eligible for tax rules that can help you save money on your taxes.

What is Net Unrealized Appreciation?

In simple terms, Net Unrealized Appreciation (or “NUA”) is the difference between the cost basis of your employer’s shares and the current market value of their shares. 

Let’s say that you contribute to your company’s 401k and over the years you accumulate a number of shares in company stock that has a cost basis of $20,000 i.e. the value of the stock when it was given to you by way of the company match. Over the years while you’re working there, your company grows, expands, and thrives. 

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By the time you retire or leave the company, the current market value of your shares has increased to $100,000. The Net Unrealized Appreciation on the value of those shares in your retirement account would be $80,000 ($100,000 minus $20,000).

How Net Unrealized Appreciation Works

When an employer provides stock as part of an employee’s retirement package, an employee has two options when they either leave or retire from a corporation. They can either 

  1. Rollover those assets in kind (keeping the stock) or liquidating to cash into an IRA or 
  2. They can move the stock to a taxable account under a special set of tax rules. 

In the first scenario, any of that stock or cash in your IRA is going to be taxed at the ordinary income tax rate, which typically means a significant percentage of that appreciated stock is going to be taxed upon withdrawal. This is particularly true if your income has already placed you in a higher tax bracket.  

The second scenario is where NUA comes into the picture. Taking advantage of an NUA strategy can be an advantageous and perfectly legal way to keep a higher percentage of the cash value of your appreciated shares by offering you a lower tax rate on the Net Unrealized Appreciation of the company stock. 

Advantages of Net Unrealized Appreciation

In the event that your employer’s 401(k) does give you the flexibility to move your shares to a taxable account, you may be able to save a considerable amount of money on the taxes you have to pay when you liquidate or withdraw the value of your shares. 

How is this possible?

Normally, when you transfer assets from a 401(k) to a taxable account, it is taxed like ordinary income. That simply means that you will end up paying taxes on the current market value of those shares when you sell them. 

Thankfully, the IRS actually offers special rules for how the Net Unrealized Appreciation of company stock is treated in tax law. These rules give you the ability to pay the income tax on the cost basis of the stock instead of the current market value, at the time you rollover your shares from your company 401(k) to your own taxable account. When you sell those company shares, you will only pay the long term capital gains tax on the Net Unrealized Appreciation of those shares and not regular income taxes.

Depending on your tax bracket and filing status, your long term capital gains rate could be 0, 15, or 20 percent on the appreciation that you had from your shares. 

The advantage to this strategy is that the taxes you pay on the Net Unrealized Appreciation of your company stock can be significantly less than if it were taxed as part of your ordinary income. 

Disadvantages of Net Unrealized Appreciation

You may not have NUA as an available strategy, depending on how your profit sharing and retirement account is set up with your employer. 

One of the major downsides of rolling over those assets (stock) from your employer’s 401(k) is that not all 401(k) packages give you the ability to rollover your shares to a taxable account. In the event that your employers 401(k) account does not give you the ability to roll over those shares, you would only be able to roll them into an IRA where they would be fully taxable as income once they are withdrawn.

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If NUA is in fact an option, it isn’t a simple process to run calculations to see if it is in fact the best option for you. A major disadvantage of exploring an NUA strategy is that it does take some work to figure out where, when, and how you need to cash out your shares to maximize your income and minimize your taxes. 

If your employers retirement account does give you the ability to roll over your shares into a taxable account, there are a few criteria that you need to meet in order for you to take full advantage of the benefits of a Net Unrealized Appreciation strategy. 

NUA Criteria

What are the boxes that you need to check in order to meet NUA criteria and to save money on the amount of taxes that you are going to pay for your shares when you sell them?

First, you need to have your companies shares in a qualified employer-based retirement account. As we mentioned earlier, this includes any company stock that is part of an ESOP, 401 (k), pension, or stock bonus plan that either you purchased with pre-tax contributions, or that your employer gave to you as a company match. 

There needs to be a qualifying event in order for this NUA strategy to be an option. The qualifying events can either be retiring from the company, reaching the retirement age, leaving the company, being injured or disabled in a way that prevents you from working, or death.  

You also need to take a lump-sum payment or distribution within the year that you leave the company. The lump-sum will include the total balance of all of your combined, qualified retirement accounts that you had at that company. 

Is Net Unrealized Appreciation the Best Choice for Me?

If you are able to take advantage of these NUA provisions, is that necessarily the best decision for you? A lot of that answer will be dependent on your specific needs and circumstances.

This is why figuring out if Net Unrealized Appreciation is the right strategy or choice for you in terms of maximizing your income and minimizing your taxes. There are a lot of variables that go into whether you should take NUA tax rates vs. income rates. 

You are going to need to do some calculations on your own, speak with an accountant, or financial advisor to see what withdrawal or investment strategy is going to lead to the best financial outcome, per your particular situation. 

Considerations for Choosing Net Unrealized Appreciation

If you are able to take advantage of NUA, whether you decide to choose that strategy or to have your shares taxed as normal income will largely depend on your tax bracket and when you decide to sell your shares. 

One of your primary considerations should be the tax bracket that you are in and if your ordinary income tax rate is going to be lower or higher than the long term capital gains tax that you are going to pay when you sell your shares, in an NUA scenario. This will lend insight into whether choosing to take your shares as ordinary income or if taking the NUA provision will help you save more. 

What is the total dollar value that your stock has appreciated during your time at the company? The more that your stock has appreciated, the greater the odds that NUA can save you money on your taxes. 

Also keep in mind that the future of your previous employer is uncertain. The company may be projected for steady growth, leading to the increase in the value of your shares and the potential for greater earnings when you sell them. On the other hand, if the value of the company declines over time, the value of the organization and your shares could decrease. 

What do you do then?

If you are only within a few years of retiring, it may be in your best interest to roll these shares over into an IRA and let them grow until you are ready to retire. 

You could wait to sell those shares until after retirement (when and if your income drops), which could potentially place you into a lower tax bracket. Even then, you would have to see if treating that sale as ordinary income would produce a higher or lower tax rate than the rate you would pay on the NUA of those shares. 

An Example of NUA

Let’s say that you are 60 years old. You earn a salary with your company that puts you into the 37% tax bracket. You were given $20,000 in company stock as a part of your company retirement account when you started your career. Over the 30 years that you worked there, the market value of those shares rose to $100,000. 

You decide that you want to sell your stock immediately to have access to that cash, so you transfer your shares from your company 401(k) to a taxable account, and sell them immediately. The long term capital gains tax you are going to pay on that stock is going to be 20% on the $80,000 that your shares increased in value, totaling $16,000. 

Now what if you roll that over into an IRA and then choose to withdraw it soon after?

You are going to pay the tax rate for your bracket (37%). In the end, this is going to cost you more in taxes vs. if you had rolled over your company stock into a taxable account and withdrew it immediately. 

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This is just one example in which NUA would be a better option, but understand that this isn’t always the case. Much of this choice depends on the unique aspects of your personal financial situation, and there are a lot of options to explore. 

If you are interested in learning more about NUA and how you can better prepare yourself for retirement and beyond, feel free to contact us today.

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About the Author

Aurtho Clint Haynes, CFPThis article was written by Clint Haynes, CFP®. Clint is a Certified Financial Planner® and Founder of NextGen Wealth. You can learn more about Clint by reading his full bio here.

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