Lump-Sum Distributions
NUA (Net Unrealized Appreciation)

Rules and Strategies for Employer Stock

IRC Section 402(e)(4)
If a company plan includes highly appreciated company stock, consider withdrawing the stock and rolling the rest of the plan assets over to an IRA. This way the plan participant will pay no current tax on the NUA or the amount rolled over to the IRA. The only tax owed would be on the cost of the stock when acquired by the plan.

NUA Tax Break for Company Stock

The mechanics of the tax break on Net Unrealized Appreciation (NUA) of company stock are relatively simple.

If a lump-sum distribution from a company plan includes highly appreciated stock or bonds of that company, the plan participant is permitted to roll it over to an IRA, but he may not want to. Although conventional wisdom says do the rollover, there is an exception that applies to company stock and works best when that stock is highly appreciated from the date the company plan (for example, a 401(k) plan) acquired it. The higher the appreciation and the lower the cost basis in the company shares, the more advantageous the company stock tax break is.

Under the special tax rule, the plan participant can withdraw the stock from the plan and pay regular (ordinary) income tax on it, but only on the original cost to the plan and not on the market value, i.e., what the shares are worth on the date of the distribution. The difference
(the appreciation) is called the net unrealized appreciation (NUA). NUA is the increase in the value of the employer stock from the time it was acquired by a plan to the date of the distribution to the plan participant.

The plan participant can elect to defer the tax on the NUA until he sells the stock. When he does sell, he will only pay tax at his current capital gains rate. To qualify for the tax deferral on NUA, the distribution must be a lump-sum distribution, but for this provision a participant does not have to have been in the plan for at least five years as he would to qualify for 10-year averaging. A lump sum means that all the assets in all like plan accounts must be distributed out of the plans.

To qualify as a lump-sum distribution for the NUA tax break, the distribution must occur in one tax year and the participant’s account balance must be zero by the end of that year.

The distribution must also occur after any one of these four triggering events:

  1. Death
  2. Reaching age 59.5 (plan is not required to allow distribution)
  3. Separation from service (not for self-employed)
  4. Disability (only for self-employed)

From the Tax Code:

IRC Section 402(e)(4)(D)

D) Lump-sum distribution. For purposes of this paragraph —

(i) In general. The term “lump-sum distribution” means
the distribution or payment within one taxable year of
the recipient of the balance to the credit of an employee which becomes payable to the recipient—

  1. On account of the employee’s death
  2. After the employee attains age 59.5
  3. On account of the employee’s separation from service, or
  4. After the employee has become disabled (within the meaning of section 72(m)(7))

Example 1:

FMV on the distribution date = $1,000,000

Cost = $200,000

NUA=$800,000

If the cost of the employer’s (company) stock in the plan is $200,000 and is worth $1 million at distribution date, ordinary income tax is paid only on the $200,000. The $800,000 of appreciation is NUA. This is no longer a tax-deferred account. When the stock is eventually sold, tax is paid on the NUA, but at current capital gain rates. If this stock were rolled over to an IRA, there would be no tax on the rollover, but when it is eventually withdrawn, the full market value would be taxed as ordinary income, at a top rate of 39.6%, more than the capital gains rate. In our example, assume the stock is sold immediately (one day) after the distribution when it was worth $1 million. There would be an $800,000 ($1 million less $200,000 cost) capital gain taxed at current rates.

Capital Gains Break
Under IRS Notice 98-24, the gain on the NUA is taxed as a capital gain, even if the stock is sold the day after the distribution. The stock does not have to be held more than one year to qualify for the capital gain rate on the NUA. Any appreciation from the distribution date through the date of sale, does not automatically qualify for the maximum capital gain rate. The stock would have to be held for the required time to qualify any further appreciation (beyond the NUA) for capital gains rates.

Example 2:

FMV on the distribution date = $1,000,000

Cost = $200,000

NUA = $800,000

Distribution date is May 15, 2013

Stock was sold on September 15, 2013 when the FMV was $1,300,000

To keep it simple, use the same facts as example 1. The cost of the stock in the plan is $200,000; the fair market value on the distribution date is $1,000,000. NUA again is
$800,000. Assume further that the distribution date was May 15, 2013, but the shares were not actually sold until four months later, on September 15, 2013, when they were worth $1,300,000. At the sale of the stock on September 15, 2013, the total gain will be $1.1 million (the total value of $1.3 million on the sale date less the original $200,000 cost to the plan). $800,000 would be taxed at a maximum capital gain rate and the balance of the gain; the $300,000 would be taxed at ordinary income tax rates, because it did not qualify as a long-term capital gain. The stock was not held long enough, measuring from the distribution date, May 15, 2013, to the date of sale, September 15, 2013, which was only four months later.

NUA, IRD, and Step-Up in Basis Rules
NUA is IRD and never receives a step-up in basis. But appreciation after the distribution date does receive a step-up in basis.

If the stock is never sold and is held until death, the heirs only pay capital gains tax on the NUA (the appreciation through the distribution date). In our example, $800,000 ($1 million less $200,000 cost) is the NUA amount.

Any appreciation from distribution date to the date of death receives a step-up in basis. In our example the $300,000 of appreciation ($1.3 million less $1 million distribution date value) receives a step-up in basis.

The NUA is reported on IRS Form 1099-R, in a separate box labeled
“Net unrealized appreciation in employer’s securities.”

When Taking the Company Stock Doesn’t Pay
If the company stock in the plan has either a high basis or is not highly appreciated, taking the company stock out of the plan could cost a bundle because ordinary income tax generally will be paid on the cost. If the cost is high, it would not be worth it to pay the tax now, unless the appreciation is much higher. For example, if the cost of the shares to the plan is $200,000 and the value at distribution date is $1 million, as in the prior two
examples, then it would be worth it to pay tax now on $200,000 and be able to defer the tax on the $800,000 of NUA. But if we change the facts now and assume the value of the shares at distribution date is only $250,000 (assume the cost is the same $200,000), it would not be worth it to pay tax now on 80% (the $200,000) of the distribution. The better option here would be to roll the stock over to an IRA and keep it growing tax-deferred. If funds were needed, they could be withdrawn from the IRA as necessary. It is true that distributions from the IRA will be taxed as ordinary income, but if NUA was used, $200,000 would have also been taxed as ordinary income at one time. But even then, there is still a sizeable tax up front and the loss of any possible tax deferred build-up. Bottom line… if the cost of the stock is high and the appreciation is low; do not go for the company stock tax break.

Exception: Specific Identification Method.
The low basis shares can be distributed (to a taxable account) and the high basis shares can be rolled to an IRA.

No Required Distributions at 70½ Years Old
When a client takes advantage of the company stock tax break on NUA, there are no more mandatory IRA withdrawals at 70½ because the stock is no longer in an IRA. They can hold the stock well past 70½ if they like and keep the NUA growing tax-deferred. However, any dividends on the stock are taxable.

10% Penalty for Employees Under 55 Years Old
If the plan participant was under 55 at the time of separation of service, she would owe a 10% penalty only on the cost basis of shares distributed prior to age 59½. If the appreciation is high enough it actually might be advantageous to pay the 10% penalty in order to preserve the tax break on the NUA. If instead the stock is rolled to an IRA, it’s true there will not be a 10% penalty (if withdrawals are not made from the IRA before 59½), but eventually ordinary income tax rates will apply on the full market value of the stock as it is withdrawn from an IRA. The age 55 exception from the 10% penalty applies only to employees who separate from service in the year they turn age 55 or later.

Distributions of NUA and Other Assets
If the plan consists of employer securities and other assets (cash, funds etc.), the non- company stock portion of the plan (the cash and funds) can be transferred into an IRA rollover account. All or part of the company stock portion can be transferred to a taxable (non-IRA) brokerage account. The company stock still qualifies for the tax break on the NUA, even if some of the shares are rolled over to an IRA. Ordinary income tax is due on the cost of the shares distributed to the plan participant. However, all plan funds and company stock must be withdrawn from the plan in one tax year to qualify as a lump-sum distribution.

Double Tax Break for Some
If the plan consists of assets in addition to the company stock (cash, funds etc.) and the non- company stock portion of the distribution is not rolled to an IRA, but instead a full distribution is taken, the taxable portion (the cost of the shares plus the other assets) may qualify for 10-year averaging. The added advantage is that the taxable portion of the stock would not have to be taxed at ordinary rates but would qualify for 10-year averaging if the plan participant were born before 1936. In addition, if there was plan participation before 1974, the plan participant may also qualify for the 20% capital gains break on that portion (it stays at 20% under the 2003 tax law). The downside here is that to gain the double tax break you must also distribute, and pay tax now on the non-company stock assets (the cash and funds, etc.), that could have otherwise been rolled over to an IRA and kept growing tax- deferred.

Election Not to Defer the Tax on NUA
If the plan participant is born before 1936, they can elect to take the distribution of employer securities and not have the tax on the NUA deferred. They could instead have the entire value of the securities (including the NUA) taxed at 10-year averaging rates. If there is little or no appreciation or the distribution is small, the tax may be less using averaging. For example, the effective tax rate on 10-year averaging exceeds the 15% capital gains rate when the distribution exceeds $125,000. If the tax on employer shares is deferred by using NUA, the capital gains tax does not have to be paid until the securities are sold.

Beneficiaries
The special NUA tax treatment is also available to a deceased plan participant’s beneficiaries. The beneficiary would still have to withdraw the entire plan balance, including the company stock and all other plan assets. The beneficiary can do a direct transfer of other assets to a properly titled inherited IRA. The NUA on the company stock would not be taxed until the beneficiary sells the stock. At the time of distribution, the beneficiary would pay tax on the original cost of the shares when acquired in the plan. If the other assets are not transferred to an inherited IRA, they would be taxed at the ordinary income tax rates of the beneficiary.

NUA Timing
The entire NUA transaction must take place within one tax year in order to qualify as a lump-sum distribution and thereby merit the tax advantage. However, an NUA transaction may take several weeks, from the time the employer makes the in-kind distribution to the time the transfer agent issues new shares. Therefore, we advise clients never to start the NUA distributions after Thanksgiving; it’s better to start the process at the beginning of the next year.

No 20% Withholding on NUA Stock Withdrawn
Generally, employers are supposed to withhold 20% of distributions from a qualified plan and send the money to the IRS, except in the case of trustee-to-trustee transfers.

There is also an exception to the withholding rule when the only remaining asset in the plan is employer stock.

Thus, distributing $500,000 worth of NUA stock might cause $100,000 to be sent to the IRS, diminishing the amount rolled over, as long as the NUA stock is not the only asset in the plan at the time of the distribution.

To avoid this outcome, most employers will first send the plan’s other assets (often cash) directly to the IRA custodian, which might be a bank or a brokerage firm, with nothing withheld because it’s a trustee-to-trustee transfer. Then the NUA shares can be distributed in-kind, with nothing left in the account to withhold for the IRS.

Most employers will follow this pattern but that’s not necessarily the case so it pays to make certain.