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. If you have employer stock in a qualified company plan it's important to be aware of these two special tax rules.
Rule #1: Net Unrealized Appreciation
Net Unrealized Appreciation (NUA) is a clunky technical term, but is 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.
However, the NUA strategy is not a given for every employee. It really depends on your situation. We use a special NUA calculator to determine if clients should use the strategy. There are other rules to follow for the NUA strategy to work. Please consult with a qualified professional beforehand, you don't want to jeopardize the special tax treatment.
Rule #2: Net Unrealized Depreciation
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. Unlike stock transactions outside of a retirement plan, the “wash sale” rule does not apply. Lowering the cost basis of the stock might improve the potential benefit of applying NUA treatment when distributing the stock from the plan in the future. This means 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.
There are other considerations. For example, investors need to analyze the tradeoffs of not using the NUA strategy and rolling over the entire balance of the company plan tax-free to an IRA upon separation from service. A rollover to an IRA may help defer the taxes longer. Or investors should weigh the merits of owning their company stock in the first place.
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.