Investors who hold employer stock (or other employer securities) as part of a qualified retirement plan may not know of the special tax rules that apply to any net unrealized appreciation (“NUA”) of their shares. As an important tax-management tool, NUA should not be overlooked by those who want to manage their distributions tax-efficiently. The requirements to qualify for NUA special tax treatment are many and intricate. It is very important that investors consult with their tax advisors before executing this option.

What is NUA?

NUA is the increase in value of employer stock while held in a qualified retirement plan. The most common types of plans that include employer stock as an investment option are 401(k) plans, profit sharing plans, stock bonus plans and employee stock ownership plans (ESOPs).

The value of an investor’s NUA is calculated at the time the employer stock is distributed from the plan as part of a lump-sum distribution. A lump-sum distribution is a payment from a qualified retirement plan of a participant’s account balance within one taxable year, due to death, attainment of age 591⁄2, separation from service (except for the self-employed) or disability (applicable only to self-employed participants). Distributions taken from a plan in a prior year may prevent a subsequent distribution from qualifying as a lump-sum distribution to the participant. All account balances of similar plans of the employer are aggregated when determining a participant’s lump-sum amount. If a distribution does not meet the lump-sum distribution requirements, only the NUA that is attributable to the participant’s nondeductible employee contributions may be excluded from gross income for tax purposes.

NUA is calculated by taking the trust’s cost basis of the employer stock in the plan and subtracting that amount from the stock’s fair market value at the time of distribution from the plan. The cost basis is determined by the trust based on the method it uses for the plan. The stock’s current value is the amount the stockholder would receive if selling the shares on the date of the distribution. NUA applies to employer stock that is actually distributed. Rolling over some of the employer stock into an IRA (or other plan) does not defeat NUA treatment for the remaining shares that were distributed, provided the other requirements are met. Rolling over non-NUA assets into an IRA (or other plan) is quite common to avoid current year income recognition on the rest of the lump-sum distribution.

Special Tax Treatment of NUA

The special tax treatment granted to NUA falls under Section 402(e)(4) of the Internal Revenue Code. Under that section of the code, the NUA that is attributable to employer stock or other employer securities distributed to a participant from a qualified retirement plan as part or all of a lump-sum distribution is not currently included in the participant’s gross income. Upon distribution, the participant pays ordinary income taxes (and the 10% penalty on premature withdrawals, if applicable) on the cost basis of the shares not rolled over.

NUA does not escape taxation completely. When distributed stock is eventually sold, any remaining NUA is considered long-term capital gain and taxed accordingly. However, this rate is typically lower than ordinary income tax rates. For example, the applicable long-term capital gains rates for 2023 are 0%, 15% and 20%; the same as they were for 2022.

NUA may offer significant tax benefits, especially for investors who hold a sizable amount of employer stock in their plan and fall within the upper income tax brackets. Increases in the value of employer stock post-distribution are taxed at either the long- or short-term capital gains rate, depending on the length of time the stock is held outside the plan after the stock is distributed. Generally speaking, gains on shares held outside the plan for more than a year are taxed at the long-term capital gains rate. Post-distribution gains on shares held outside the plan for a year or less are short-term capital gains, which are taxed at the same rate as an individual’s ordinary income tax rate. The holding period for the shares begins on the date following the date the shares are delivered to the transfer agent with instructions to re-issue the stock in the employee’s name.

Please note, your employer stock can decline in value significantly after distribution from the plan. The benefit of the NUA rules should be balanced against the risk that the stock will decline in value. The value of the stock may go down while inside the plan or after it’s distributed. If the value of the stock decreases and it is sold for less than the distribution value, only the remaining NUA (not the full NUA at the time of the distribution), if any, will be taxable. If, after it’s distributed, the value of the stock decreases to an amount below the participant’s cost basis in the stock, the participant avoids tax on the NUA and may be able to realize a loss (for the amount below basis) in the year the stock is sold.

Regarding the 3.8% net investment income tax, NUA is not considered net investment income, but it could push the taxpayer over the NUA threshold. Any post-distribution gains will be considered net investment income and could be subject to the 3.8% tax.

Tax Considerations for Beneficiaries

If a plan participant dies after receiving a distribution of employer stock, the NUA is considered “income in respect of a decedent.” The plan participant’s beneficiaries will pay long- term capital gains taxes on any NUA when they sell the shares; however, they will not be taxed on any increase in the value of the stock from the point of distribution until the date of death of the participant. In essence, they receive a step-up in basis in the stock for any gains accrued during that period. Any gain in the stock’s value following the owner’s death, however, will be taxable to the beneficiaries as a long-term capital gain.

Important Concepts for Preserving NUA

Investors may lose the beneficial tax treatment associated with NUA if their employer stock is:

Sold in the plan and the proceeds are paid out from the plan in cash
Paid in a non-lump-sum distribution (in this case, only the NUA attributable to nondeductible employee contributions receives special tax treatment)
Rolled over into an IRA (the special long-term capital gains tax rate does not apply to IRA distributions)

In some plans, participants may self-direct the buying and selling of employer stock in their accounts. If available, this option should be exercised with caution. Investors can reduce their potential NUA significantly if they are frequently buying, selling and then repurchasing shares at a higher price. Such activity requires the plan to reset the cost basis each time, which could negatively affect the participant’s NUA.

NUA in Action

The following scenarios illustrate the tax ramifications of taking a lump-sum distribution that includes employer stock. Note that these assumptions are based on current tax law (as of January 2023). Future legislative changes could significantly alter the results illustrated. The 10% additional tax for
early withdrawal may apply along with income taxes when withdrawing funds from a tax-deferred investment.

Scenario 1

Using the facts in the example on page 1, 62-year-old plan participant Ellie takes a lump-sum distribution of employer stock upon leaving her company. She will need to pay ordinary income taxes on the cost basis of $150,000 in the year of distribution. She will not be subject to an early withdrawal 10% additional tax because she was at least age 55 when she severed employment and took this distribution. Assume, because of Ellie’s other income, all of this income falls in the 35% tax bracket. Her federal income tax liability associated with the stock in the year it is distributed will be $52,500 ($150,000 of basis x 35%). She will not be taxed on the NUA portion ($200,000) until she sells the stock.

Scenario 2

Three years after receiving her distribution, Ellie notes that the value of her shares has increased to $400,000. If Ellie decides to sell the shares, her NUA ($200,000) could be taxed at the long-term capital gains rate (assume 15%), or $30,000. The additional $50,000 increase in the stock’s value also will be taxed at the long-term capital gains rate because of the length of time she held the stock outside the plan. The $50,000 of additional gain will result in a tax liability of $7,500 ($50,000 x 15%), for a total tax bill in year three of $37,500 ($30,000 + $7,500).

Scenario 3

Assume the same facts as in the example on page 1, except that Ellie does not sell her stock. Instead, she holds it outside the plan until her death, nine years after receiving the distribution valued at $350,000. At the time of her death, her shares are worth $600,000.

Sam’s $400,000 basis in the inherited shares is Ellie’s basis ($150,000), plus any appreciation between distribution and death ($250,000). When Sam decides to sell all of his inherited shares, $200,000 of gain is NUA taxed as long-term capital gain. Any additional gain on the stock from the point of Ellie’s death until Sam sells the stock is also taxed as long- term capital gain, regardless of the length of time Sam holds the stock, due to a special rule for capital gain and loss on inherited property. If he sells all of the stock immediately, for $600,000, his $200,000 gain is all NUA, and assuming a long- term capital gains rate of 15%, his tax bill will be $30,000.

Scenario 4

Assume the same facts as in the example on page 1, except this time Ellie does not sell the stock and three years later Ellie’s employer declares bankruptcy. The value of Ellie’s stock is now zero and she has already paid $52,500 in taxes (assuming a 35% tax bracket). A tax advisor can help her decide how to treat this stock. Hopefully, Ellie has other assets to fund her retirement years. This is why tax savings should always be a secondary consideration when developing a retirement investment strategy.

NUA & 401k Plans — Source: Employee Benefits Research Institute, “EBRI Issue Brief No. 557,” May 3, 2022.

Looking Ahead

Most plans that currently offer employer stock as an investment option are likely to continue doing so in the coming years. That said, more plan sponsors are likely to educate their participants about the potential advantages of greater diversification.

Although there are no regulatory limits to the amount of company stock any participant may hold, all plan sponsors have a fiduciary duty to manage their plans in the best interests of their participants. This includes, among other responsibilities, the obligation to select options that are appropriate for the plan and to monitor those investments on an ongoing basis to ensure they remain suitable for plan participants. If a plan offers company stock as an investment option or makes matching contributions with company stock, the employer must make an objective, prudent assessment as to whether the stock is an appropriate investment for the plan’s participants.

A portfolio concentrated in a single security is subject to sudden and dramatic losses. The potential effects on participants and their retirement security could be devastating should they over-invest in the stock of a sponsoring employer. This is also true for individuals who decide to take advantage of the NUA strategy and continue to hold employer stock after terminating employment.

Expanded Diversification Rules

As of 2007, all plan participants making voluntary salary deferrals, as well as those receiving employer-provided contributions (e.g., nonelective and matching contributions) who have at least three years of service, must be allowed to direct these amounts to alternative investments. In both cases, the alternative investments must consist of at least three investment options (other than employer stock) that are diversified and have materially different risk and return characteristics. Plan participants should consult with a financial advisor or their plan sponsor if they have questions about their investment options.

Other Options for Stock Distribution

The decision of whether to pursue an NUA strategy as opposed to selling company stock in the plan or rolling over distributed shares into an IRA should be made only after careful consideration is given to an investor’s financial circumstances and goals. While the potential tax benefits of an NUA strategy are appealing, this solution is not appropriate for all investors.

Consider, for instance, the tax treatment of any dividends earned on stock held outside a plan.

In the case where the shares feature dividend payments, it may be more advantageous to roll the shares into an IRA to shelter that income stream from current taxation. That said, the tax rate on qualified dividends for 2023 align with the same income brackets that apply for the long-term capital gains tax rate, rather than the brackets for income tax.

When considering a distribution of employer stock, many factors should be weighed, including:

Does the participant feel strongly about owning the stock?
What limitations, if any, does the plan impose?
Does the participant understand the volatility of the stock and have other sufficient assets in the event the stock does poorly or becomes worthless?
Is the participant under age 59 ½ (or under 55 in a separation of service instance)? If so, an early distribution 10% additional tax may apply.
Does the participant have sufficient funds to pay the taxes due upon distribution?
Does the benefit of tax deferral in an IRA outweigh the tax benefit of the NUA?
What are the participant’s legacy plans for any beneficiaries?
When does the participant plan to sell the stock?

Conclusion

A great number of retirement plan participants hold employer stock as part of their investment portfolios. Yet many investors tend to overlook the potentially significant tax benefits associated with the NUA of their shares. Plan participants, especially those nearing retirement, should consider consulting with a financial advisor to determine if an NUA strategy is right for them. Some questions to discuss:

Do you have employer stock in your defined contribution plan?
What is your employer stock concentration related to your overall retirement portfolio?
What is the plan’s cost basis in the stock?
What is your NUA?
What is your current tax bracket, and do you expect it to change?
What are the tax ramifications of following an NUA strategy on some or all of the employer stock in the plan?
What is your intention related to the stock, to sell immediately or to hold it?

When considering an NUA strategy, the first step is to determine whether holding employer stock is a good investment strategy for the particular investor. If it is, the next step is to perform an NUA analysis with a trusted advisor. By doing so, plan participants could help maximize the potential tax benefits of owning company stock.

If you’d like to discuss your company stock options and how you can potentially use it to achieve your financial goals, please feel free to contact me anytime.

(1) National Center for Employee Ownership, Employee Ownership by the Numbers, December 2021.

(2) A 10% early withdrawal additional tax may apply to the amount of the cost basis if the lump-sum distribution occurs before age 591⁄2 or if separated from service before age 55.

(3) Consideration for the 10-year tax option available to plan participants born before January 2, 1936, is beyond the scope of this paper.

(4) Whether a rollover is the right decision is a question that should only be answered after considering all available options (e.g., withdrawing the assets, leaving the assets in the plan or rolling them to an IRA or another employer’s plan), taking into account such things as availability of investment options, fees and expenses, services, taxes and penalties, creditor protection, required minimum distributions and the tax treatment of employer stock.

Source: Columbia Threadneedle