Journal of Financial Planning: December 2016
Robert A. Westley, CPA/PFS, CFP®, is an associate wealth adviser with Northern Trust in New York City. He specializes in developing, implementing, and monitoring holistic financial plans and wealth management solutions for high net worth families.
Clients who are approaching retirement are often tasked with navigating myriad decisions with respect to their qualified and non-qualified retirement and employee benefit plans. And once in retirement, retirees must make critical choices as to which retirement assets to withdraw to meet their everyday living expenses. As a financial planner serving this demographic, it is vital to counsel clients and provide a thoughtful analysis on their retirement distribution options in order to maximize cash flow and preserve after-tax wealth. This column will concentrate on a lesser-known distribution option and offer financial planners advice to help their clients decide which option is best.
What Is NUA?
Net unrealized appreciation, or NUA, refers to the appreciation in the value of company stock held in an employer-sponsored qualified retirement plan, from the time the stock was originally placed into the account to the time the stock is distributed. For example, say an employee receives or buys 100 shares of company stock in their qualified workplace plan when the stock is $50 per share, and three years later the stock appreciates to $80 per share. The current market value of $8,000 consists of $5,000 of cost basis and $3,000 of NUA.
In general, funds held in qualified retirement plans are subject to ordinary income tax treatment immediately upon distribution. However, the Internal Revenue Code favorably treats distributions of NUA in certain situations, allowing for tax deferral on the NUA portion until the company stock is actually sold, and then applying the long-term capital gains tax rates (Sec. 402(e)(4), I.R.C.). It is important to note that the election for NUA treatment is only available for stock issued by the employing company. Therefore, any other investments that may be held in the employer-sponsored qualified plan will not qualify for this income tax treatment.
Components of Company Stock Taxation
Before a financial planner begins to analyze the NUA election, it is imperative to have a clear understanding of the tax attributes of the different components of company stock within the context of NUA.
The first component, which is the plan’s cost basis of company stock, is subject to ordinary income tax immediately upon distribution. Furthermore, the 10 percent early withdrawal penalty will apply to the taxable cost basis if the employee is under age 59½, unless he or she is at least 55 and there is a complete separation from service.
The next component is the net unrealized appreciation in company stock at the time of distribution. This portion is only subject to tax once the shares are subsequently sold and subject to long-term capital gains tax rates. The NUA portion of the gain is not included in net investment income and therefore not subject to the 3.8 percent Medicare surtax. The planner should also be aware that the NUA component does not receive a step-up in cost basis at death because it is considered income in respect of a decedent (IRD).
The third component, post-distribution appreciation of the company stock, is subject to short-term or long-term capital gains tax depending on the holding period. This portion of the gain will be included in net investment income and subject to the 3.8 percent Medicare surtax. At death, the post-distribution appreciation will receive a full step-up in cost basis.
The decision as to whether to take the NUA distribution or rollover the employer stock is a quantifiable decision. When advising clients on NUA, it is essential to quantify and evaluate the cost of upfront taxes with future appreciation taxed at capital gains rates, versus the benefit of pre-tax compounding on the gross rollover amount with future distributions taxed as ordinary income. As with most financial decisions, the financial planner should help the client run the numbers and model out the economics of the available options before arriving at a conclusion. Additionally, in order to achieve the greatest result for clients, a holistic approach should be taken.
The following considerations should be explored when considering NUA as a part of a client’s retirement distribution plan:
Tax rates. A key benefit of NUA is the application of the more favorable long-term capital gains tax rates rather than the higher ordinary income rates. For 2016, long-term capital gains are taxed at 0 percent for gains in the 10 and 15 percent tax brackets; 15 percent for gains in the 25 to 35 percent tax brackets; and 20 percent for those in the 39.6 percent bracket. Therefore, the benefits of NUA increase when the spread between capital gains and ordinary income tax rates increases.
A taxpayer with a high marginal tax rate for ordinary income will make a good candidate. However, the planner should also gauge whether there are any opportunities for taxpayers in lower brackets to harvest capital gains in the 10 percent or 15 percent income tax brackets, as these gains will be taxed at 0 percent. Finally, the effect of possible future changes in the tax law made to the ordinary or capital gain tax rates need to be considered.
The amount of NUA and cost basis. Because the cost basis will become immediately taxable upon distribution, the NUA strategy is most impactful when the employee has highly appreciated, low-basis company stock. Financial planners could add value by advising clients who are nearing retirement to discontinue buying company stock or contributing to an employer stock fund. This will help minimize the upfront tax on the cost basis, should an employee choose NUA treatment upon departing from service. The planner must also evaluate whether the qualified plan contains after-tax contributions that can be applied to the cost basis of the NUA shares. This may enable the client to distribute company stock shares from the plan tax-free.
Time horizon. The timing and amounts of cash flow needed in retirement is a crucial factor of the NUA analysis. The financial planner should assist the client in mapping out the various sources and amounts of retirement income and liquidity available to them. This will help determine the timeframe for when the assets will need to be consumed. The NUA election will be attractive when the investment time horizon is rather short. Otherwise, the longer the client plans to keep their assets invested in an IRA rollover, the greater the benefit of that account’s tax-deferred compounding growth. Although distributions are fully taxable as ordinary income, over time the tax-deferred growth can be a substantial benefit. The planner will need to run the numbers to determine which option yields the greatest after-tax outcome.
Diversification. The decision to hold a concentration of employer stock over long periods of time needs to be closely examined and monitored within the NUA framework. The planner should note that the NUA election will result in a tax cost in order to diversify, whereas the client is able to diversify without a tax bite within an IRA rollover account. If the client’s overall portfolio is heavily weighted in company stock, the risk of downside loss may be greater than the potential tax savings from distributing and holding the NUA shares.
Creditor protection. Asset protection planning must also be addressed within the NUA decision. Assets that are held in an IRA or employer plan are entitled to significant protection from creditors. The creditor protection will be lost if the stock is held in a taxable brokerage account. The cons of losing a layer of asset protection must be weighed within the individual context of the client’s risk profile.
Charitable giving. As with other highly appreciated assets, NUA shares distributed from a qualified plan may be an advantageous asset to use for charitable giving. Clients may consider contributing some or all of the NUA shares to a charitable remainder trust (CRT) or donor advised fund (DAF). The charitable income tax deduction may even offset the tax obligation due on the basis upon distribution. The planner will need to assess the donative intent of the client to determine if a charitable strategy makes sense.
Estate planning. Planners should be sure to consider any estate planning goals their clients may have. If a large portion of a client’s wealth is located in an employer retirement plan, it may prove difficult to equalize their estate between themselves and their spouse. A distribution of NUA stock will provide the ability to title assets between both spouses, ensuring each one has enough individual assets to absorb the current estate and generation-skipping transfer tax exemption amounts.
Final Thoughts
Although the NUA election may not be fitting in every situation, it is always an important consideration for financial planners to analyze whenever an employee departs from service holding company stock in a qualified retirement plan. The potentially beneficial NUA treatment will be irrevocably lost once the account is rolled into an IRA.
Retirement distribution decisions can certainly be nuanced. As a financial planner it is critical to run the numbers and help the client think through each alternative. You can add value to your relationships by devising a thoughtful, cohesive plan to keep clients on course toward achieving their financial goals, within the holistic context of their financial situation, investment horizon, risk tolerance, and resources.