Tax savings available under the net unrealized appreciation election
ARTICLE | November 02, 2022
Authored by RSM US LLP
What is net unrealized appreciation?
Taxpayers with employer stock in their retirement plan account should be aware of a potential tax saving strategy, the net unrealized appreciation (NUA) election allowed under Section 402(e)(4). The election is not common but can result in significant tax savings under the right circumstances.
NUA is the gain on employer stock held within an employer sponsored retirement plan. The essence of making the NUA election is a decision to pay taxes sooner, at a blend of ordinary income rates on the cost basis (i.e., purchase price) and long-term capital gains on the NUA gain when the shares are sold, rather than rolling over to an Individual Retirement Account (IRA) and deferring taxation (all at ordinary income rates) until withdrawals are taken from the IRA.
Requirements for the NUA election
- A triggering event must have occurred. The event does not have to occur in the same year the taxpayer makes the election, it could have been several years in the past. Triggering events are separation from service, attainment of age 59 ½, disability (within the meaning of Section 72(m)(7)), or death.
- A distribution cannot have occurred between the time of the triggering event and the election. For example, a taxpayer who terminated employment in YY01 and received a partial distribution from the plan account that year, could not make a NUA election in YY03 when the remainder of the retirement plan account is distributed.
An exception to this would be if there was another triggering event which occurred after the partial distribution. Considering the same facts, if the taxpayer attained age 59½ in YY02, a NUA election could be made after that event.
- The shares of employer stock held within the retirement plan must be distributed in-kind to a taxable brokerage account. Not all of the shares have to be included in the election. The taxpayer can “cherry pick” (Treasury Regulation 1.402(a)-1(b)(2)(ii)(A)) the shares with the lowest cost, as highly appreciated shares provide the greatest opportunity for a successful result. However, to be able to choose the most highly appreciated shares, the cost basis from the time of purchase must be available at the individual share level.
- The taxpayer’s entire plan balance, not just the employer stock portion, must be distributed in the same calendar year. The non-stock balance, if any, can be distributed to the taxpayer, which would be taxable, or it can be transferred (rolled over) to an IRA or other qualified plan to remain tax deferred.
The cost basis in the shares is immediately taxable as ordinary income when an in-kind transfer occurs. The portion of the account attributable to NUA will be taxable at long-term capital gain rates when the stock is sold (IRS Notice 98-24). If the stock is not sold immediately, any gains after the distribution will be taxed (short-term or long-term capital gains rates apply, as applicable) based on the holding period from the date of distribution through the date of sale (IRS Notice 98-24). The NUA gain is not considered net investment income (NII); therefore, it is not subject to the 3.8% net investment income tax. However, gains on the stock between the distribution date and the sale date would be considered NII and potentially subject to the tax (Treasury Regulation 1.411-8(b)(4)(ii)). It also should be noted that the NUA tax deferral is not permanent, Revenue Ruling 75-125 provides that the NUA at the time the stock was distributed will be taxable when sold, even if the stock is sold after death, essentially the NUA is income in respect of a decedent in the hands of the beneficiary. In other words, a step-up in basis at death does not apply to the NUA.
Simplistic example based on a 35% ordinary income tax rate and 15% capital gain rate for an in-kind stock distribution sold immediately (and not rolled over) after distribution.
Tax if no NUA election
Tax if NUA election made
Tax savings from NUA election
The example shown above is labeled “simplistic” for a reason. Making the NUA election can initially appear to be the most beneficial choice; however, there are other considerations which should be factored into the decision of whether to make the election. If the entire retirement plan balance was rolled to an IRA and invested tax deferred, would the earnings over the time held in a tax deferred account out distance the tax savings of a NUA election? Would the in-kind distribution and subsequent sale of stock move the taxpayer into a higher tax bracket for ordinary and/or capital gain rates? If the stock is not immediately sold after distribution, does holding the stock create an investment concentration risk? What are the taxpayer’s cash flow needs? Would it make sense to sell the stock over time to satisfy cash flow needs at the lower long-term capital gain rate, rather than distributing funds from a tax deferred account at ordinary income rates?
The NUA election is a choice and not a requirement, so each taxpayer’s situation should be examined closely for feasibility. Tracking the cost basis of employer stock within the retirement plan matters as not all the stock must be included in the election. This allows for use of only the most highly appreciated stock for the election. And, finally, the stock does not have to be sold immediately upon distribution. Only the cost basis will be taxed at ordinary income rates at the time of distribution. The stock can be sold over time and the appreciation taxed at more advantageous capital gain rates when sold.
This article was written by Christy Fillingame and originally appeared on 2022-11-02.
2022 RSM US LLP. All rights reserved.
The information contained herein is general in nature and based on authorities that are subject to change. RSM US LLP guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. RSM US LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein. This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer.
RSM US Alliance provides its members with access to resources of RSM US LLP. RSM US Alliance member firms are separate and independent businesses and legal entities that are responsible for their own acts and omissions, and each is separate and independent from RSM US LLP. RSM US LLP is the U.S. member firm of RSM International, a global network of independent audit, tax, and consulting firms. Members of RSM US Alliance have access to RSM International resources through RSM US LLP but are not member firms of RSM International. Visit rsmus.com/about us for more information regarding RSM US LLP and RSM International. The RSM logo is used under license by RSM US LLP. RSM US Alliance products and services are proprietary to RSM US LLP.
Talbot, Korvola & Warwick, LLP is a proud member of the RSM US Alliance, a premier affiliation of independent accounting and consulting firms in the United States. RSM US Alliance provides our firm with access to resources of RSM US LLP, the leading provider of audit, tax and consulting services focused on the middle market. RSM US LLP is a licensed CPA firm and the U.S. member of RSM International, a global network of independent audit, tax and consulting firms with more than 43,000 people in over 120 countries.
Our membership in RSM US Alliance has elevated our capabilities in the marketplace, helping to differentiate our firm from the competition while allowing us to maintain our independence and entrepreneurial culture. We have access to a valuable peer network of like-sized firms as well as a broad range of tools, expertise and technical resources.
For more information on how Talbot, Korvola & Warwick can assist you, please call (503) 274-2849.