In many large (publicly traded) companies, it’s common to reward employees with employer stock. Usually through a profit-sharing or ESOP plan, or at least by allowing employees to purchase stock themselves inside of their 401(k) plan. The disadvantage is when you withdraw money from a company plan, it is taxed as ordinary income. However, the IRS - if you can believe it - has two special rules to help: Net Unrealized Appreciation (NUA) and Net Unrealized Depreciation (NUD). However, given the stock market volatility, it’s the NUD rule that piques my interest right now.
First things first – understand the NUA rule
Net Unrealized Appreciation (NUA) is a clunky technical term but an important potentially tax-savings opportunity for those with company stock in their employer plan. Under the NUA rule, only the cost basis of the shares is subject to tax (and potentially an early withdrawal penalty) at the time of the distribution. In simple terms, the cost basis is what a person pays for the stock. The net unrealized appreciation is the growth of the stock above the cost basis. When you leave the employer and want to take a withdrawal of company stock from the retirement plan, if you follow the NUA rules, there could be a substantial tax savings, here's how:
The NUA is not subject to ordinary income tax until the company stock is sold and will never be subject to an early withdrawal penalty. When the stock is sold, the NUA is subject to tax at capital gains rates — not ordinary income tax rates, which can be much higher, depending on your income and current tax rates. Additionally, the NUA is not subject to the 3.8% Medicare surtax on net investment income. The favorable tax treatment for the NUA portion of company stock distributions is what we call the NUA rule.
Why NUD now?
A similar sounding name, but different strategy all together, is Net Unrealized Depreciation or NUD. Participants holding company stock within a retirement plan that has decreased sharply in value may want to consider resetting the cost basis of that stock by selling the stock within the plan and repurchasing it shortly thereafter inside the plan. Unlike stock transactions outside of a retirement plan, the “wash sale” rule does not apply. We call this "stepping-down" the cost basis.
Why consider "stepping-down" the basis? A bigger gap between the cost basis - what you paid for the stock - and the potential growth from that point forward creates more opportunity to apply the NUA rule in the future. The NUD strategy is particularly important now given the stock market volatility. If you have employer stock in your company retirement plan, consider reviewing the cost basis versus the market price. If the current stock price is lower than your cost basis, that may be an opportunity to apply the NUD strategy – selling the stock and immediately buying back within the plan to step down the cost basis. (Be sure to check with your plan administrator prior to implementing either the NUA or the NUD strategy to ensure your plan allows.)
There are many considerations to making the NUA election. It really depends on the individual’s situation. The NUD strategy is a little less complex, you are only resetting your cost basis. However, stepping-down your cost basis may give yourself potentially more of an opportunity to apply the NUA rule in the future if you do so choose the NUA election upon retirement. Most of all, investors should weigh the merits of owning their company stock in the first place. A high concentration – more than 10% of the portfolio in a single stock – is risky in my opinion.
There is much to consider when evaluating an NUA or NUD strategy. I advise clients not to go it alone. Our NUA calculator is a helpful tool to quantify the potential tax benefits. But it's not just about NUA and NUD, it's about taking a holistic look at the pieces to your retirement and your financial plan. An experienced professional can help you see the big picture, explain the advantages and disadvantages, and help you make the right decision.
If you want to learn more or discuss your financial planning, please feel free to email me for a complimentary consultation.
"I work with busy executives to help them get more out of their personal tax and financial planning."
Michael Aloi, CFP
Read more here:
Kiplinger: Should You Take the Pension or Lump-sum?