Most investors know that using a company-sponsored retirement plan can be a great tool for tax efficiency. On pretax contributions to these plans, one drawback is that all of the distributions are taxed as ordinary income. However, in some circumstances, there are even further tax efficiencies when using company stock in a company-sponsored retirement plan or employee stock ownership plan (ESOP). In these plans gains can be taxed at long-term capital gains rates, as opposed to ordinary income, in what is known as Net Unrealized Appreciation (or NUA if you want to sound cool). Although not all plans allow company stock to be purchased in a 401k, NUA can be quite a valuable tool to help save on taxes if used correctly.
There are three rules of Net Unrealized Appreciation:
1. NUA transactions can only be made after a triggering event.
Triggering events include:
- Reaching age 59 ½
- Separation of service (i.e., leaving a job)
- The participants death
2. The shares of stock on which NUA is desired must be moved in-kind to a taxable account.
When the company stock is transferred, that triggers the basis to be taxed as ordinary income. However, the gain can be retained to sell later and would be taxed at the long-term capital gains rate. The logistics of an NUA transaction are very important. Typically, when you move funds out of a 401(k), you would do so as a rollover from the employer retirement plan to an IRA. For the shares that will get NUA treatment, you would have those transferred in-kind into a non-qualified (taxable) investment account instead.
3. The employer-sponsored plan must be emptied within one calendar year.
This means in the year that the in-kind transfer is completed (i.e., the employer-sponsor plan is emptied), the remaining mutual fund shares or other company stock must be distributed from the company sponsored plan. This could be (and likely would be) a rollover to an IRA to retain tax deferral on the contributions. It is worth noting that the triggering event and the year that the plan must be emptied do NOT have to be the same here. In fact, it can be advantageous to wait until a year or two after the triggering event, depending on someone’s tax situation.
Planning Strategies for Net Unrealized Appreciation
When we think about strategy around a net unrealized appreciation transaction, we want to consider what the objective is. Broadly, it can be a tax saving transaction if you’re using appreciated stock for charitable giving. It can also be a tax-generating transaction if you’re selling the stock to fund the first few years of retirement. Your objective would help determine your strategy and whether you would perform the transaction in a high-income year or in a low-income year.
In simple terms, when income is high you may want to defer or reduce income. You could use charitable gifts to accomplish this objective. When income is low you may want to accelerate income. You could use selling the NUA stock at long-term capital gains rate to accomplish that objective.
Two common strategies would be:
- Use all or a portion of the company stock to fund the first few years of retirement spending.
- In this scenario, the individual may have the triggering event be separating from service. Then the following year, when they’re in a lower tax bracket, they would perform the NUA transaction and pay tax on that gain at capital gains rate.
- Use the appreciated stock to fund charitable giving.
- This would be a tax savings strategy and the donor would use the appreciated stock to fund charitable giving. This would be subject to a 30% of adjusted gross income (AGI) limit. This works especially well in the last year of someone’s retirement because their income is likely still higher. In this scenario the individual would get a tax deduction on their higher income, as opposed to a deduction in future years at their lower income.
Let’s spell out both scenarios in each case study below.
Case study #1
Sarah works for XYZ Inc., a publicly traded company. Sarah retires at age 64 and is intending to draw Social Security at age 66. She has $700,000 in her 401(k), of which she has $100,000 in XYZ stock with a cost basis of $20,000. She is hoping to cover her $50,000 a year in expenses with her company stock for two years until she draws Social Security.
A strategy that Sarah might consider would be to perform an NUA transaction on $100,000 of company stock. She might consider doing this the year after she retires, because then she would likely be in a lower tax bracket. When she performs the NUA transaction, the $20,000 of basis will be taxed at ordinary income and the remaining $80,000 would be taxed at the long-term capital gains rate. She could consider an additional strategy of not realizing the entire gain in one year so that she could stay in the 0% long-term capital gains rate. For tax year 2022 for someone that is married filing jointly the 0% long-term capital gains rate goes up to $83,350. For Sarah, using a strategy like this could save her nearly $10,000 in taxes if done correctly. This is because she could be realizing those gains at 0% as opposed to 10% and 12% if she was taking those distributions taxed as ordinary income.
Case study #2
Tim, age 65, works for a private company with an ESOP that offers in-kind distributions. Tim retires and typically gives $20,000 a year to his church. He plans to do the same over the foreseeable future. Tim, while working, is in the 32% tax bracket, but when he retires, he expects to drop down to the 22% tax bracket. Tim has $800,000 in his company ESOP with a basis of $100,000 and would like to use a portion to fund some of his charitable giving through retirement.
In this situation it would be advantageous for Tim to do the NUA transaction in the same year that his income is still relatively high. This may be in the year he retires, or it could be the year prior since he already had a triggering event of reaching age 59.5.
Tim would do a portion of the ESOP stock as an in-kind transfer to his non-qualified investment account. The cost basis on the $100,000 that he is electing to transfer to his nonqualified account would be $12,500. This portion would be taxed as ordinary income. Once this portion of the transaction was complete, he would then gift $100,000 worth of ESOP stock that now has a basis of $12,500 to either a charity or to his donor advised fund.
The advantage to bunching all these charitable contributions into one tax year is that he is getting that tax deduction while he’s in the 32% tax bracket, as opposed to the 22% tax bracket. Additionally, that nearly $90,000 worth of gain is being gifted to the charity of his choice where he is not having to realize it. Using this strategy would result in nearly a $30,000 tax savings. That would be a 10% savings on the tax deduction ($100,000 * 32%-22%), and a 15% savings on the gifting of the appreciated stock at nearly $90,000 as opposed to giving $20,000 of cash over the next five years.
Net unrealized appreciation is simply a tool in the tool belt, it’s neither bad nor good. As you can see from the example case studies. Considering NUA as part of a tax savings strategy before or while entering retirement can be complex. The good news is that it’s typically something an individual would only do one time in their life. The details are very important on NUA transactions but, if done correctly, the potential tax savings can make it well worth the extra work they take.
Next Steps
If you feel your retirement and planning tax strategies like NUAs are too important to be doing it by yourself and want to delegate the heavy lifting to an expert, we offer a no-obligation, no-cost second opinion that you can:
- Get started by clicking here,
- Email us at info@sonmorefinancial.com to discuss, or
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