When it comes to advising executives how best to manage their finances, I find we quickly jump from basic to more complex strategies. Executive planning typically has more intricacies involved. One such executive strategy we often run into is: Net Unrealized Appreciation. You see, many executives are heavily concentrated in their company’s publicly traded stock — stock options, restricted units, and even large portions of their 401(k). Basically, they have company stock falling out of their pockets (although beats what is falling out of my pocket these days soiled burp cloths!) Whether good, bad, or indifferent, I see it every day. There are some very sophisticated and interesting tax strategies which might make sense when pertaining to stock positions in your work retirement plan. One of my favorites is the aforementioned Net Unrealized Appreciation (better known as NUA).
What is NUA? NUA is a way to extract money invested in your company’s stock, which is held in your company 401(k). It allows you the ability to pull the entire company stock out of the plan, while receiving special tax treatment. You’ll pay ordinary income tax on the basis and have more favorable long term capital gains on the growth through the years. For Example, if you purchased company stock for $50,000 (and now it’s worth $150,000), you would pay the ordinary income rate on the $50,000 of basis and long term capital gains on the $100,000 of growth. Alternatively if you just pulled the stock out of the 401(k) normally you would pay ordinary income tax on the entire $150,000. The 7 Steps. I highly suggest you work with a professional before attempting the NUA process on your own, for there are a lot of moving parts and potential pitfalls. Here are some critical things to know before you even begin down this rabbit hole.
Step 1: You must have a qualifying event to be eligible to utilize NUA. A qualifying event is classified as separation from service, attaining age 59.5, death, or disability. Then (and only then) you can move to step 2.
Step 2: You must not have taken money out of your 401(k) after reaching a qualifying event. Thus, if you are reading this, are 62 years old, and took some funds out of your 401(k) two years ago, you are out of luck. The only caveat here is if you attain a new qualifying event. Then, you have the option of resetting. Therefore, if you separated service and took money out at 58 years old, you can still do the NUA if you attain 59.5 (another qualifying event) and haven’t taken anything out since attaining age 59.5.
Step 3: You must withdrawal the full amount of your 401(k) in the calendar year you begin withdrawing. This doesn’t mean you can’t take a portion of these funds (let’s say the 401(k), non-company stock portion) and roll it into an IRA while utilizing NUA for the company stock. This just needs to occur in the same calendar year. For instance, you have $1,000,000 in your 401(k). $250,000 is company stock and $750,000 is mutual funds. You could take the $250,000 and move it a brokerage account. Then you can perform the NUA and roll the $750,000 into an IRA with a financial advisor.
Step 4: You must transfer this stock in-kind to a brokerage account. Work with your financial planner and plan administrator to set this up. It’s very important to not sell the stock. Make sure you have a brokerage account setup to transfer those stocks directly without selling them first. (As an aside you can also utilize the NUA strategy on privately held companies through an ESOP plan. The only wrinkle is it may be harder to transfer the funds in-kind, but conceptually it can be done.)
Step 5: Enter the tax man. Upon transferring, you will be responsible for owing ordinary income tax on the basis immediately. If you are under 59.5, you’ll be hit with an additional 10% penalty as well on that basis. If you simply sell the entire amount right away after transferring, you’ll be responsible for ordinary income tax on the basis and long term capital gains on the gain. Important to note no matter when you acquired the stock, once transferred in-kind, the entire growth at that time is treated as long term capital gains.
Step 6: Do you sell immediately or hold it? If you sell immediately, you’ll clearly have the cash on hand to pay the tax bill on basis and long term capital gains. This is the simplest way to handle it. If you hold the stock, you’ll have two things to consider. First, you will you have to find a way to pay the tax on what could be a sizeable bill. Secondly, any further gain or loss from that point will be treated like normal brokerage account gains. For instance, you bought the stock for $50,000. Now, it’s worth $150,000 and you move ahead with NUA. You’ll owe the taxes on the $50,000, as we’ve established. If you hold the $150,000 for 6 more months and it grows to $175,000, you’ll now owe long term capital gains on the $100,000 of initial gain and short term capital gains on the $25,000 additional gains, since you held it for less than one year. It’s also worth mentioning, there is no Medicare surtax on the NUA capital gains. So, you are only subject to a potential three long term capital gain rates on just the NUA growth portion. They are 0%, 15%, or 20% respectively.
Step 7: Keep copious records, especially if not selling right away. Make sure you track every last movement. It is very easy to lose track and you are likely moving funds between multiple institutions. That said, a lot of this data can get lost in the shuffle. When that day comes to meet the tax man, you want to have well-documented record keeping.
To NUA or not to NUA, that is the question? Although NUA can be a very beneficial strategy, it is certainly not right for everyone. There are a lot of things to consider, such as what it does to your taxes and how these funds will no longer be growing tax deferred. It can be a great savings strategy. But, like anything when it comes to tax and financial strategies, make sure you are able to sift through all the pros and cons as they pertain to your life.