Net Unrealized Appreciation in a Nutshell
As your clients approach retirement or change employers, they may be considering what to do with their qualified plan assets. In many cases, clients transfer their assets into another qualified plan or roll funds to a traditional IRA. If distribution of employer securities is involved, clients may be better off taking distributions in a lump sum instead of rolling assets to another plan.
That’s because Internal Revenue Code Section 402(e)(4) provides favorable tax treatment if a qualified plan distributes employer securities to a former employee (plan participant). Specifically, the former employee may be eligible to pay the more advantageous long-term capital gains tax rate on the net unrealized appreciation (NUA) of the employer securities.
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For retirees who have employer securities, in their employer sponsored qualified plan (e.g. 401(k) plan), there are special advantages to taking a distribution of the securities.
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At distribution, the employee pays ordinary income tax on the cost basis of the employer securities.
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When sold, NUA is taxed at the long-term capital gains rate.
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NUA vs. IRA Rollover Calculator available to analyze tax implications of NUA.
Key Features of Net Unrealized Appreciation
Employer Securities
The employer, the parent corporation, or the subsidiary corporation issues employer securities and contributes them to the employee's qualified plan account. In many cases, the securities are employer stock, but may include corporate bonds or debentures.
Distribution of Securities
At retirement, the qualified plan distributes employer securities to the former employee. Generally, the qualified plan distributes the employer securities in a lump sum after the employee meets a "triggering event," such as separation from service, reaching age 59½, disability, or death.
Taxation
At distribution, the employee pays ordinary income tax on the cost basis of the employer securities, which is the value of the securities at the time the employer originally contributed them to the qualified plan. NUA is the excess of the fair market value of the employer securities at the time of the lump-sum distribution over the cost basis mentioned above.
Furthermore, unless the former employee has an exception to the additional 10% federal tax (i.e., attained age 55 or older and separated from service), the additional federal tax will apply.
Lump-Sum Distribution
Generally, the former employee may exclude NUA from ordinary income only if the qualified plan distributes the employer securities in a lump sum. NUA in employer securities distributed in other than a lump-sum distribution is excludable only to the extent that the appreciation is attributable to nondeductible employee contributions.
A lump-sum distribution is payment of a plan participant's entire balance (within a single tax year) from all the employer's qualified plans (e.g., pension, profit-sharing, or stock bonus plans). The qualified plan administrator reports the NUA amount to the Internal Revenue Service on IRS Form 1099-R, box 6.
The NUA remains tax-deferred even though the former employee neither transfers nor rolls the employer securities into an IRA, but instead deposits the securities into a taxable account.
Sale of Employer Securities
When the former employee receives the lump-sum distribution from the plan, the NUA amounts attributed to the increase in the securities’ value from the date the employer contributed them to the plan until the date the plan distributes them to the former employee is taxed at the long-term capital gains rate upon disposal of the asset. In addition, if the employee receives the securities in-kind and disposes of them at a later date, any appreciation on the securities from the date of distribution until the date of sale will be taxed at the long-term capital gains rate if held for more than one year.
Scenarios of Lump-Sum Distribution
Scenario 1: Highly Appreciated Employer Stock
| Employee's cost basis = $50,000 |
| Market value at distribution = $200,000 |
| Appreciation = $150,000 |
This hypothetical example illustrates how a lump-sum distribution of highly appreciated employer securities may benefit the former employee. The former employee will pay ordinary income tax on the $50,000 cost basis. In addition, unless the former employee has an exception to the additional 10% federal tax (i.e., attained age 55 or older and separated from service), it will apply to the taxable amount. However, the $150,000 in appreciation will be taxed at the long-term capital gains rate when the employer securities are sold. Future appreciation will also be taxed at the long-term capital gains rate if the former employee holds the employer stock for more than one year.
Scenario 2: Employer Stock- No Growth
| Employee's cost basis = $50,000 |
| Market value at distribution = $5,000 |
| Appreciation = $0 |
This hypothetical example illustrates how a lump-sum employer stock distribution with no appreciation will affect the former employee. The former employee will pay ordinary income tax on the $50,000 cost basis, but no NUA exists. Any subsequent appreciation will be taxed at the long-term capital gains rate if the former employee holds the employer stock for more than one year.
In this instance, the favorable tax treatment of paying long-term capital gains tax on the NUA amount does not exist. Thus, the client may be better off keeping the assets within the plan or rolling the distribution amount into an IRA.
Decision Time: Rollover/Transfer vs. Lump-Sum Distribution
The former employee must carefully decide whether to roll the value of the employer securities or to receive a lump-sum distribution. Although employees receive tax deferral if they transfer/roll the employer securities’ value into an IRA or a qualified plan, they will pay ordinary income tax on any future distributions. As shown above, NUA is taxed at the long-term capital gains rate.
However, the former employee may consider foregoing the lump-sum distribution and rolling over the employer securities’ value into an IRA for the following reasons:
- Ordinary income tax is due on the cost-basis of the employer securities in the year of receipt.
- If the former employee is younger than age 55 when separated from service, an additional 10% federal tax may apply to the in-kind stock distribution. Note: An additional 10% federal tax may also apply to IRA distributions prior to age 59½.
- Beneficiaries do not receive a “step-up” in cost basis if the former employee dies.
- The former employee’s investment portfolio within the retirement plan may lack diversification.
- The net tax benefit may be marginal if the stock has not appreciated greatly.
- The distribution may move the former employee into a higher tax bracket.A large capital gain may trigger the Alternative Minimum Tax.
NUA vs. IRA Rollover Calculator
A useful tool to analyze the tax implications of net unrealized appreciation from an employer's qualified plan versus an IRA rollover.
Since everyone’s situation is unique, former employees should consult their tax advisors to determine whether a lump-sum distribution or a rollover is appropriate.