What is Net Unrealized Appreciation (NUA)?
Hi everyone, my name is Tan and I am an independent Certified Financial Planner practitioner at TAN Wealth Management. Today’s educational video is on net unrealized appreciation strategy. What is net unrealized appreciation (NUA)? The word “net” is the total minus expense. The fair market value of the employer stock minus the cost basis of the employer stock equals the net profit or loss of the employer stock. Unrealized appreciation is the “paper” profit of the employer stock. It’s realized when the employer stock is sold. For example, you have investments in your account that go up and down daily. That’s the unrealized gains and losses because you have not sold the investments. When you sell the investment, you realize the gains or losses of the investments.
What is the net unrealized appreciation strategy?
When we have employer stock in a defined contribution plan, such as in a 401(k) plan or an employee stock ownership plan (ESOP), we can transfer the employer stock in-kind during a qualifying event, pay ordinary income tax rates on the employer stock cost basis and pay long-term capital gains tax rates on the net unrealized appreciation amount which is the difference between the employer stock fair market value and cost basis.
To do the NUA strategy, we must satisfy three requirements.
1. The employer stock must be transferred in-kind,
2. It’s part of a lump-sum distribution,
3. And satisfied a triggering qualifying event.
The net unrealized appreciation (NUA) qualifying events are:
● Separation from service (we are no longer with the company)
● Reached age 59½
● Death
● Total disability for self-employed workers. If you are not self-employed and you work for a company and become totally disabled, chances are, you are no longer with the company. Thus, you can trigger the event of separation from service.
For example, Luna is separated from service when she is 40-years-old. She had the option to do the NUA strategy but she didn’t because she didn’t know about the NUA strategy. The next time she can do the NUA strategy is when she is 59½-year-old. If Luna passed 59½-year-old when she separated from service and didn’t do the NUA strategy, she had to wait for another qualifying event. If she doesn’t have a qualifying event to do the NUA strategy, her beneficiary can do the NUA strategy when she deceased.
The two net unrealized appreciation (NUA) taxable events are:
1. A taxable event when we do an NUA strategy. We pay ordinary income tax rates on the employer stock cost basis.
2. A taxable event when we sell the employer stock. We pay long-term capital gains tax rates on the net unrealized appreciation plus any gains above that amount will be taxed at long-term capital gains tax rates if we held the employer stock more than 365 days and short-term capital gain tax rates if we held the employer stock for 365 days or less. If we have a subsequent loss instead of a gain, we can claim the loss as a capital loss.
Net unrealized appreciation strategy examples.
To better understand the net unrealized appreciation strategy, let’s look at some examples.
What did we learn from the examples?
NUA strategy is good when we have a very low-cost basis in the employer stock. If we roll over our defined contribution plan to a Traditional IRA, we can have tax-deferral and the ability to do a Roth conversion in the future. There is also an opportunity for our spouse to roll over our IRAs to theirs when we are deceased. This can stretch the plan distributions for many years.
Disadvantages of the NUA strategy are:
● We need money to pay for the taxes on the employer stock cost basis when you do the NUA strategy.
● Opportunity cost on the tax payment. Every time we spend a dollar on something, we are not spending that dollar on something else. That is the opportunity cost.
● We are giving up tax-deferral.
● We are giving up the ability to do a Roth conversion in the future.
● No step-up in basis in the employer stock.
● The unsystematic risks associated with holding an individual stock. In theory, we do not compensate investors for unsystematic risks because the risks can be eliminated through diversification. Examples of unsystematic risks are management risk, business risk, and financial risk.
What did I personally do with my employer stock in my 401(k) plan?
When I was at Prudential Financial, I had Prudential Financial stock and mutual funds inside my 401(k) plan. I could have done the NUA strategy by transferring in-kind the Prudential Financial stock to a brokerage account and the mutual funds to a Traditional IRA. I didn’t do that because having Roth money is more important to me than paying long-term capital gains tax rates on the gains of the Prudential Financial stock. I transferred all of my 401(k) plan money to a Traditional IRA then did a Roth conversion when the market was down in March 2020. I know my taxable income will increase because of the Roth conversion, but in the long run, I know I will be better off because all of that money in the Roth IRA will be tax-free to me when I use it in the future.
Should conservative investors do the NUA strategy?
Don’t make investment decisions solely on the tax implications. If we are conservative investors, we should not have a high concentration in a stock position. Although the tax benefits make sense to do the NUA strategy after we did our analysis, we should not do the NUA strategy if we are conservative investors. I know we can do the NUA strategy by paying ordinary income tax rates on the employer stock, strategically selling the employer stock, and being taxed at long-term capital gains tax rates on the net unrealized appreciation, then take the money and invest it in a diversified portfolio. The risk here is the employer stock price could decline dramatically when we want to sell the employer stock. Thus, conservative investors should think twice before doing the NUA strategy.
Does the 3.8% net investment income tax apply to the net unrealized appreciation?
Under Treasury Regulation 1.411-8, except for distributions from qualified plans, the 3.8% “net investment income does not include any distribution from a qualified plan or arrangement. For this purpose, the term qualified plan or arrangement means any plan or arrangement described in section 401(a), 403(a), 403(b), 408, 408A, or 457(b).” We just pay the long-term capital gains tax rates of 0%, 15%, or 20%, plus state income taxes if applicable. (Source: law.cornell.edu)
Does the 10% early withdrawal penalty apply to the NUA strategy?
We could be subject to a 10% early withdrawal penalty on the employer stock cost basis if it’s not a qualified distribution, such as not reaching age 59½. For example, Luna is 50-years-old and her employer’s stock cost basis is $10,000. She did the NUA strategy, $10,000 is taxable at ordinary income to her and she may also be subject to the 10% penalty which is $1,000.
Net unrealized appreciation strategy insights
● NUA strategy might make sense if we need the money to achieve our life goals, such as a down payment on a house, start a business, et cetera. If we need the money and don't do the NUA strategy, all of the proceeds will be taxed at ordinary income tax rates. If we do the NUA strategy, the employer stock cost basis will be taxed at ordinary income tax rates and the net unrealized gain will be taxed at long-term capital gains tax rates. Thus, we can save money in taxes by doing the NUA strategy.
● The best time to do the NUA strategy is when we have a very low-cost basis in the employer stock.
● Cherry-pick the employer stock that makes sense to do the NUA strategy. It doesn’t make sense to do an NUA strategy when the employer stock is in a profit-sharing plan, like a 401(k) plan. We can sell the employer stock, then do the NUA strategy. That way, we can transfer in-kind the employer stock we want in a brokerage account and the remaining investments and money inside the 401(k) plan can be rollover to a Traditional IRA and we can take advantage of all the benefits that come with the Traditional IRA, such as tax-deferral and the ability to do a Roth conversion.
● Before doing the NUA strategy, make sure you are qualified to do it. Talk to a professional that knows the ins and outs of the NUA strategy. I like to be on a conference call with my clients and their employer’s or ex-employer’s Human Resources Departments so I can ask their Human Resources Departments specific questions related to their plans.
Tax rules are constantly changing. What is correct right now might not be correct in the future. Always talk to a qualified professional before making any financial decision. If we do the NUA strategy wrong, the full value of the plan can be taxed at ordinary income tax rates. What are your thoughts on the NUA strategy? Does it make sense to do it?
Thank you for watching. Until next time, this is Tan, your trusted advisor.