Net Unrealized Appreciation, NUA, What is It?
Having accomplished a lot of financial planning for Silicon Valley executives in Palo Alto and San Jose, the concept of Net Unrealized Appreciation became a topic of importance for those who hold a lot of company stock. Oftentimes, significant value of company stock are held in qualified retirement plans such as 401k. Failing to understand your options for your stock can result in excess taxes that could have been avoided. So what is Net Unrealized Appreciation, or NUA, and what are the most important aspects of this that should be understood?
The text book definition of NUA is the “difference in value between the average cost basis of shares and the current market value of the shares held in a qualified retirement plan. Take a look at the following illustration.
Credit: Rollan Dizon, RED 13Ventures
Under this strategy, employees can elect a lump sum distribution of their company stock from their retirement plan to their taxable account (Brokerage stock account) and pay ordinary income taxes on the stock’s basis, NOT the entire value of their stock position. In this example, the stock value is $100, but the cost basis is $10, therefore, ordinary income tax is paid on the basis of $10. The difference, $90, is considered the NUA, and is subject to preferential long term capital gains tax regardless if they sold it a day after taking it from their retirement plan, or years after. As you can see, there are potential advantages, as well as disadvantages by making this election.
When can you Elect This?
One of four special events must have occurred before you can take this election. They are the following:
- Separation from Service from the company who holds the stock
- Total Disability as defined under the Tax Code
- Attaining age 59.5
When making this election for those under 55 (special rules of qualified company plans), a 10% Premature penalty will apply but only to the value of the basis. In our example, this tax and penalty will only apply to $10 of the $100 value of the stock.
Other Tax Considerations
Remember that your NUA will always be taxed at Long Term Capital Gains rate; however, subsequent appreciation is taxed at either Short Term Capital Gain or Long Term Capital Gains depending on how long you hold your stock before selling.
If you are considering electing an NUA distribution of your company stock, please, please, jot down these important considerations.
- Give yourself a reminder that all plan (401k account as an example) assets must be withdrawn and distributed COMPLETELY in a single year (often times end of the calendar year of your NUA election). Pay particular attention to any residual contributions after you made this election from your employer or last paycheck contribution.
- You can elect NUA for part of the shares and the rest can be rolled into your rollover IRA account. Once you distributed those shares to your personal IRA, you can no longer make this election
- You may want to ask your plan’s record keeper for your stock’s cost basis and lots, so you can take advantage of electing NUA in your stock with low cost basis
- NUA is considered income in respect of a decedent and is part of the estate
- There is no step up in basis available for NUA (upon death), but beneficiaries can still use long term capital gains rates for NUA. The appreciation in excess of NUA will receive a step up in basis at time of death
As you now have strong knowledge of the Net Unrealized Appreciation election I hope you are empowered in making the right decision as it pertains to your company stock held in retirement accounts. There are dozens and dozens of scenarios where it makes sense to elect and where it does not make sense. Important things to think about are your shares’ average cost basis, your time horizon and your mix of investments. Importantly, your tax situation both now and in the future will need to be considered. Stay tuned for future articles that dig deeper into how this election can empower you to make profitable decisions as you make this important election.