Tax savings available under the net unrealized appreciation election

What is net unrealized appreciation?

Taxpayers with employer stock in their retirement plan account should be aware of a potential tax saving strategy, the net unrealized appreciation (NUA) election allowed under Section 402(e)(4). The election is not common but can result in significant tax savings under the right circumstances.

NUA is the gain on employer stock held within an employer sponsored retirement plan. The essence of making the NUA election is a decision to pay taxes sooner, at a blend of ordinary income rates on the cost basis (i.e., purchase price) and long-term capital gains on the NUA gain when the shares are sold, rather than rolling over to an Individual Retirement Account (IRA) and deferring taxation (all at ordinary income rates) until withdrawals are taken from the IRA.

Requirements for the NUA election

• A triggering event must have occurred. The event does not have to occur in the same year the taxpayer makes the election, it could have been several years in the past. Triggering events are separation from service, attainment of age 59 ½, disability (within the meaning of Section 72(m)(7)), or death.
• A distribution cannot have occurred between the time of the triggering event and the election. For example, a taxpayer who terminated employment in YY01 and received a partial distribution from the plan account that year, could not make a NUA election in YY03 when the remainder of the retirement plan account is distributed.
  
  An exception to this would be if there was another triggering event which occurred after the partial distribution. Considering the same facts, if the taxpayer attained age 59½ in YY02, a NUA election could be made after that event.
• The shares of employer stock held within the retirement plan must be distributed in-kind to a taxable brokerage account. Not all of the shares have to be included in the election. The taxpayer can “cherry pick” (Treasury Regulation 1.402(a)-1(b)(2)(ii)(A)) the shares with the lowest cost, as highly appreciated shares provide the greatest opportunity for a successful result. However, to be able to choose the most highly appreciated shares, the cost basis from the time of purchase must be available at the individual share level.
• The taxpayer’s entire plan balance, not just the employer stock portion, must be distributed in the same calendar year. The non-stock balance, if any, can be distributed to the taxpayer, which would be taxable, or it can be transferred (rolled over) to an IRA or other qualified plan to remain tax deferred.

Tax treatment

The cost basis in the shares is immediately taxable as ordinary income when an in-kind transfer occurs. The portion of the account attributable to NUA will be taxable at long-term capital gain rates when the stock is sold (IRS Notice 98-24). If the stock is not sold immediately, any gains after the distribution will be taxed (short-term or long-term capital gains rates apply, as applicable) based on the holding period from the date of distribution through the date of sale (IRS Notice 98-24). The NUA gain is not considered net investment income (NII); therefore, it is not subject to the 3.8% net investment income tax. However, gains on the stock between the distribution date and the sale date would be considered NII and potentially subject to the tax (Treasury Regulation 1.411-8(b)(4)(ii)). It also should be noted that the NUA tax deferral is not permanent, Revenue Ruling 75-125 provides that the NUA at the time the stock was distributed will be taxable when sold, even if the stock is sold after death, essentially the NUA is income in respect of a decedent in the hands of the beneficiary. In other words, a step-up in basis at death does not apply to the NUA.

Simplistic example based on a 35% ordinary income tax rate and 15% capital gain rate for an in-kind stock distribution sold immediately (and not rolled over) after distribution.

Other considerations

The example shown above is labeled “simplistic” for a reason. Making the NUA election can initially appear to be the most beneficial choice; however, there are other considerations which should be factored into the decision of whether to make the election. If the entire retirement plan balance was rolled to an IRA and invested tax deferred, would the earnings over the time held in a tax deferred account out distance the tax savings of a NUA election? Would the in-kind distribution and subsequent sale of stock move the taxpayer into a higher tax bracket for ordinary and/or capital gain rates? If the stock is not immediately sold after distribution, does holding the stock create an investment concentration risk? What are the taxpayer’s cash flow needs? Would it make sense to sell the stock over time to satisfy cash flow needs at the lower long-term capital gain rate, rather than distributing funds from a tax deferred account at ordinary income rates?

Takeaway

The NUA election is a choice and not a requirement, so each taxpayer’s situation should be examined closely for feasibility. Tracking the cost basis of employer stock within the retirement plan matters as not all the stock must be included in the election. This allows for use of only the most highly appreciated stock for the election. And, finally, the stock does not have to be sold immediately upon distribution. Only the cost basis will be taxed at ordinary income rates at the time of distribution. The stock can be sold over time and the appreciation taxed at more advantageous capital gain rates when sold.