NUA tax rule for company stock
Updated: Jun 8
So, you are ready to retire and receive your well-earned ESOP distribution? You are a little scared and realize you only get one shot at this? Well read this article to have an understanding about how the Net Unrealized Appreciation (NUA) rule effects the tax treatment of your company held stock in your 401k, profit-sharing plan, or Employee Stock Ownership Plan (ESOP).
FIRST THING TO UNDERSTAND WHEN LEAPING RETIREMENT: Retirees need to realize that there is a lot of correct information out there that conflict with each other. The reason being is that you must understand there are various strategies. Retirement planning has more to do with varying strategies then “right or wrong”. Within these varying strategies there are certain forward-looking predictions that must be made. Whether or not those predictions evolve to be true certainly affect whether you chose the right strategy or not. The trick is to make sure when your assumptions are incorrect the situation is still tenable. This is certainly true among a retirement containing ESOP’s and retirement’s that do not.
SECOND THING TO UNDERSTAND WHEN RETIRING WITH AN ESOP: Taxes, taxes, and taxes. This is a major part of your strategy. You will have to decide whether to pay taxes immediately at a lesser rate or defer the taxes and pay a higher rate in the future. This is where the Net Unrealized Appreciation strategy collides with the option to simply rollover assets into an IRA. Of course, there is always the option of a blended strategy. Most of the time that is the necessary path to take.
STEP 1: Understand the Net Unrealized Appreciation tax rule (NUA treatment). In laymen’s terms, this is a tax rule that allows employees to accept their purchased company stock in retirement accounts or gifted company stock with two applicable tax treatments. For simplicity, I will acknowledge all company stock as if it were “gifted” in a profit-sharing plan or Employee Stock Ownership Plan (ESOP). Please know that the NUA rule applies to purchased stock in a 401K as well.
First, the gifted stock (known as cost basis) amount will be taxed at the higher ordinary income rate. The ordinary income tax amount becomes immediately due upon the distribution. The appreciation amount of the stock will be taxed at a lower more favorable long term capital gains tax rate. This appreciation tax bill will only come due when the stock is sold. The employee can receive their stock, hold it in a brokerage account, and wait years before they decide to sell. This presents an opportunity to defer taxes for a very long time. Eventually the tax bill will come due as these shares are not privy to the step-up basis at death. However, due to a need to diversify, this stock is often sold immediately.
FOR EXAMPLE: John Smith’s company has gifted him $250,000 (the cost basis) worth of stock over his 20-year tenure with ABC company. The company stock appreciates to a value of $2,000,000. John Smith elects to receive all his stock using the NUA treatment. He will pay ordinary income tax on the $250,000 (cost basis) immediately and then long-term capital gains on the remaining $1,750,000 upon the sale.
QUALIFICATIONS TO USE THE NUA TAX RULE:
Distribution in Kind: After a qualifying trigger event (separation of service, retirement, disability, or death), the stock must be distributed in kind as part of a lump sum distribution. This is kind distribution simply means the stock must be transferred away from the employers. The employee can’t sell the stock before the transfer or sell the shares, and repurchase the from the company at a later date.
Lump sum distribution: To take advantage of the NUA rule, the entire account balance of the employer retirement account must be distributed in a single tax year. Ultimately, all of the employee stock, cash, and any other assets must be removed from the employer accounts.
For example, an employee has $100,000 in company stock. The employee also has $50,000 in mutual funds in their retirement account. Both assets must be transferred from their employer retirement account. However, the mutual funds can be rolled over into a Roth or traditional IRA to defer taxes.
The lump-sum distribution must occur after a qualified trigger event: These trigger events will either be death, disability, separation from service, or reaching age 59.5.
THIRD THING TO UNDERSTAND WITH AN ESOP: The cherry pick. It is allowable to cherry pick which shares an employee would like to distribute in kind. The rest of the shares can be rolled over into an IRA to delay the taxable event. However, the individual shares must have been originally earmarked pursuant to Treasury Regulation 1.402(a)-1(b)(2)(ii)(A).
It is important to scrutinize the cost basis of the gifted share price. For Example:
An employee receives $10,000 worth of gifted stock 20 years ago from ABC company at $5/share. The company performs well and the shares are now worth $200/share with a total value of $400,000. The cost basis of $10,000 will be taxed at ordinary income rates. The appreciation of $390,000 will be taxed at long term capital gains upon sale of the shares. The same employee last year received another $10,000 worth of gifted stock at $170/share. Clearly it would behoove the employee to cherry pick the earlier held shares with the NUA rule. The shares at the $170/share tranche only has seen an 18% gain. The NUA rule would tax the bulk of the $10,000 via ordinary income. This is an undesired result. In this example, the higher cost basis shares would want to be rolled over into an IRA ignoring the NUA opportunity.
SUMMARY: It is vital to understand that the NUA rule isn’t a mandatory path to take when a stock distribution occurs. It is simply an applicable tax strategy depending upon your cost basis of shares. The NUA rule also is a great tool when an employee needs cash in the present. Perhaps the employee wants to use the NUA rule for immediate tax savings in order to diversify.
It’s important to note that once shares are sold using the NUA rule in a taxable brokerage account. Then the newly diversified shares are now going to continue to be taxed moving forward. Whereas shares moved into an IRA can be sold, taxes withheld, and then continue to grow tax free. The downside to this strategy is upon IRA withdrawals the recipient will pay the higher ordinary income tax.
If you need help with your profit-sharing plan or ESOP feel free to reach out to J.A. Lawrence Wealth Management.