Many employers are utilizing the option to compensate employees by giving them shares of employer stock, in addition to their salary. If your employer gave you stock in the company you work for, you must understand how net unrealized appreciation (NUA) effects the stock that you have received. It is essential to be informed of the special tax considerations in the way that employer stock can be taxed, allowing you to maximize your gains and minimize tax liability when the assets are distributed from your employer-sponsored retirement plan.
What Is Net Unrealized Appreciation?
Net unrealized appreciation is defined as the difference in value of the original cost basis of employer stock shares versus their present-day market value. It only applies to stock in the company you work/ed for, which must be held in your traditional IRA or 401(k). NUA comes into play when you want to distribute those stock assets from your plan.
What Happens upon the Distribution of Employer Stock?
This is where it’s important to understand the difference between the original cost basis of the employer stock versus the current market value of the stock at the time of the distribution. The original cost basis is the value of the stock at the time you acquired it. When it is time to distribute this employer stock from your employer plan, it is likely that the stock has appreciated since the time you acquired it (i.e., net unrealized appreciation).
When you take distributions from any tax-deferred retirement plan, you owe tax on those distributions. Normal distributions during retirement are considered ordinary income and are taxed at the ordinary income tax rate. However, distributions of employer stocks from your retirement plan can be treated a bit differently and are taxed in two ways.
When you distribute the employer stock from your retirement plan, you’ll pay tax immediately on the original cost basis of the stock at ordinary income rates. The “Net Unrealized Appreciation” of the stock can be taxed at the long-term capital gains rate when following the NUA rules. Typically, LTCG are taxed at a significantly lower rate compared to ordinary income, and thus lowers your tax liability on the appreciated stock.
The Caveats of Net Unrealized Appreciation
For NUA tax treatment to kick in and work to your advantage, you must meet specific qualifiers per IRC Section 402(e)(4):
- The employer stock must be distributed in-kind to a taxable investment account.
- You must take a lump-sum distribution of your entire employer retirement plan (not just the employer stock, but all assets in the account) in one tax year. However, you can withdraw some or all of the employer stock and roll the remaining stock and other assets over into a new IRA (which is typically how it’s done to avoid taxation and early withdrawal penalties on your hard-earned retirement funds).
- A qualified “triggering event” (death, disability, separation from service) must predicate this lump-sum withdrawal. Turning 59 ½ is also considered a triggering event, so long as the distribution is taken after you reach that age.
- You can choose to hold the NUA gains in another account for an extended timeframe (up until the day you die). But NUA gains do not enjoy the step-up in basis upon your death—so your beneficiaries can expect to pay tax on that when the time comes and in compliance with IRS rules.
Take Steps to Ensure You Make the Most of NUA Gains
Net unrealized appreciation can be quite complex to navigate. There are multiple tax considerations you must understand above and beyond the basics explained in this article. The NUA strategy can be a beneficial one when utilized correctly but there is a trade-off as well. It is crucial to understand how much NUA there really is before deciding whether to employ this approach.
The rule-of-thumb regarding NUA is that it is most advantageous for highly appreciated employer stocks. Consult with your financial advisor for proper guidance that suits your personal situation before you distribute these stocks from your plan.
This article was written for general informational purposes only and should not be considered legal, financial, or tax advice. Seek appropriate counsel for further details and information.