The Fading Allure of NUA

By John H. Robinson, Owner/Founder, Fee-Only PLanning Hawaii  

Net Unrealized Appreciation, or NUA is a relativevely obscure tax-planning strategy available to retirees and employees leaving their jobs with a pile of company stock in their retirement accounts . It is a special provision in the Internal Revenue Code that allows employees who hold appreciated company stock in their 401(k) plans or Employee Stock Ownership Plans (ESOPs) to potentially pay substantially less in taxes when they distribute the shares.

A couple of decades ago, NUA was a particularly attractive planning strategy. Today, it is less so.

In nearly 40 years as a financial planner, I have considered NUA strategies for numerous clients. I have actually implemented the strategy exactly twice, and both instances were more than 20 years ago.

Here's why this once-popular tax-planning technique has largely fallen out of favor.

What Is Net Unrealized Appreciation?

Ordinarily, when you take money out of a traditional 401(k) or ESOP, the entire distribution is taxed as ordinary income. If you are younger than age 59½, you may also be subject to a 10% early withdrawal penalty.

NUA provides a special exception for appreciated employer stock held in a qualified retirement plan.

Under the NUA rules, an eligible employee may distribute company stock in kind from the retirement plan into a taxable brokerage account rather than rolling it into an IRA.

The employee pays ordinary income tax on the original cost basis of the shares, but the appreciation that occurred while the stock was held in the retirement plan is not taxed until the shares are sold. Better still, that appreciation is taxed at favorable long-term capital gains rates, regardless of how long the shares are held after distribution.

The NUA portion is also exempt from the 10% early withdrawal penalty. However, the original cost basis may still be subject to that penalty if the employee is younger than 59½ and does not qualify for another exception.

To qualify, the distribution generally must occur after a triggering event, such as separation from service, reaching age 59½, disability, or death. The participant must also satisfy special lump-sum distribution requirements, which generally involve distributing the entire balance of the applicable retirement plan within a single tax year.

An Example of How NUA Works

Suppose you have $100,000 of company stock in your 401(k) or ESOP, and the original cost basis of those shares is just $10,000.

That means $90,000 represents net unrealized appreciation.

If you roll the stock into a traditional IRA and eventually withdraw the entire $100,000, the distribution will generally be subject to ordinary income tax.

However, if you qualify for NUA treatment, you can transfer the stock into a taxable brokerage account and pay ordinary income tax on just the $10,000 cost basis.

The remaining $90,000 of appreciation is not taxed until you sell the shares, at which point it receives long-term capital gains treatment.

Assuming you are in the 24% federal marginal income tax bracket and the 15% long-term capital gains bracket, the comparison looks like this:

In this simplified example, NUA saves $8,100 in federal income taxes, assuming the entire IRA withdrawal would be taxed at 24% and the stock is sold immediately after distribution.

That sounds pretty attractive. And it can be.

But there is more to the story.

Why NUA Was More Attractive 20 Years Ago

Two decades ago, federal marginal income tax rates were considerably higher for many middle- and upper-income households.

The top federal marginal income tax rate was 39.6% before the 2001 tax cuts, and many successful professionals faced marginal rates of 28%, 31%, or higher.

Meanwhile, the long-term capital gains tax rate fell to 15% for many investors in 2003.

The opportunity to convert what would otherwise be ordinary income into long-term capital gains represented a potentially enormous tax savings.

Today, the math is often considerably less compelling.

Many middle- and upper-middle-income retirees fall into the 22% or 24% federal marginal income tax brackets. Their effective federal income tax rates, after accounting for deductions and lower tax brackets, may be substantially lower than their marginal rates and, in some cases, approach the federal long-term capital gains tax rate.

That reduces the relative benefit of NUA.

One Important Advantage: NUA Avoids the 3.8% Investment Income Tax

There is, however, one important tax advantage of NUA that deserves special attention.

The Affordable Care Act introduced the 3.8% Net Investment Income Tax (NIIT), which generally applies to investment income when modified adjusted gross income exceeds $200,000 for single filers or $250,000 for married couples filing jointly.

For taxpayers subject to this tax, the effective federal long-term capital gains rate can increase from 15% to 18.8%, or from 20% to 23.8%.

Here is the interesting part: The original net unrealized appreciation on qualifying employer stock is specifically exempt from the 3.8% NIIT.

In other words, if you distribute company stock with a $10,000 cost basis and $90,000 of NUA, the $90,000 appreciation will not be subject to the NIIT when the shares are sold.

However, any additional appreciation that occurs after the shares leave the retirement plan may be subject to the surcharge.

This is a meaningful benefit that is sometimes overlooked in NUA planning discussions. For higher-income taxpayers who would otherwise be subject to the NIIT, the exemption preserves a potentially valuable tax advantage.

Still, it does not necessarily make NUA the best choice. The tax comparison must also account for the investor's future ordinary income tax rates, the timing of withdrawals, and state income taxes.

Hawaii Makes NUA Less Attractive

Hawaii offers a particularly good illustration of why NUA strategies must be evaluated on a state-by-state basis.

Hawaii generally taxes long-term capital gains at a maximum rate of 7.25%.

For a Hawaii resident in the 15% federal capital gains bracket, the combined federal and Hawaii tax rate on qualifying NUA appreciation can reach 22.25%.

Because the original NUA appreciation is exempt from the NIIT, there is no additional 3.8% surcharge on that amount.

Nevertheless, 22.25% is a far cry from the 15% federal capital gains rate that makes NUA sound so attractive.

Of course, Hawaii also taxes ordinary retirement plan distributions, so a proper comparison must account for state taxation on both sides of the equation. In fact, Hawaii's ordinary income tax rates can be substantially higher than its capital gains rate, which may preserve an NUA advantage for some taxpayers.

The point is that the federal tax savings cannot be considered in isolation.

For some Hawaii residents, NUA may still generate meaningful tax savings. For others, particularly those who expect to take IRA distributions in lower tax brackets over many years, the advantage may be surprisingly small or disappear altogether.

The Risk of Keeping Too Much Company Stock

There is another important consideration that is too often overlooked in discussions about NUA.

Tax savings should never be the sole determinant of an investment decision.

One of the fundamental principles of prudent portfolio management is diversification.

Employees who accumulate large positions in their employer's stock are already taking substantial financial risks. Their salaries, employment prospects, and retirement savings may all be tied to the fortunes of a single company.

NUA may provide an incentive to maintain that concentrated position because selling the shares triggers the deferred capital gains tax.

However, that is a tax consideration, not an investment strategy.

To be fair, NUA does not require investors to retain the stock indefinitely. They can sell the shares immediately after distribution and still receive long-term capital gains treatment on the qualifying appreciation.

But if the objective is to sell the stock and diversify, the resulting capital gains tax must be considered alongside the alternative of rolling the shares into an IRA, selling them inside the IRA without triggering immediate tax, and managing distributions over time.

For many retirees, the ability to diversify immediately and control the timing of future taxable IRA distributions may be worth more than the potential NUA tax savings.

An Arrow That Rarely Leaves My Quiver

I am not suggesting that NUA is obsolete.

For employees with very low cost-basis company stock, unusually high ordinary income tax rates, and favorable capital gains tax circumstances, NUA can still provide meaningful tax savings.

The exemption from the 3.8% Net Investment Income Tax is another legitimate advantage, particularly for high-income taxpayers.

It is especially worth examining when a substantial portion of a retirement account consists of highly appreciated employer stock.

However, as with most tax-planning strategies, the devil is in the details.

The strategy must be evaluated in the context of the client's current and projected future tax rates, state of residence, investment diversification needs, retirement income requirements, and estate planning objectives.

Over the decades, I have considered NUA for numerous clients with ESOPs and large company stock positions in their 401(k) plans. I have implemented it only twice, and both occasions were more than two decades ago.

Today, NUA remains one of the many tax-planning provisions I keep in mind whenever I encounter clients with significant employer stock holdings in their retirement plans.

But it is an arrow that rarely finds its way out of my quiver.

RELATED READING

Understanding Net Unrealized Appreciation (NUA) (Fidelity)

Net Unrealized Appreciation (NUA): Tax Treatment & Strategies (TurboTax)

IRS Notice 98-24 - Net Unrealized Appreciation in Employer Securities

Haw. Code R. § 18-235-7-03 - Exclusion of pension income