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Net unrealized appreciation: The untold story

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By Doug Awad

If you participate in a 401(k), ESOP, or other qualified retirement plan that lets you invest in your employer’s stock, you need to know about net unrealized appreciation – a simple tax deferral opportunity with an unfortunately complicated name. When you receive a distribution from your employer’s retirement plan, the distribution is generally taxable to you at ordinary income tax rates.

A common way of avoiding immediate taxation is to make a tax-free rollover to a traditional IRA. However, when you ultimately receive distributions from the IRA, they’ll also be taxed at ordinary income tax rates. (Special rules apply to Roth and other after-tax contributions that are generally tax free when distributed).

But if your distribution includes employer stock (or other employer securities), you may have another option – you may be able to defer paying tax on the portion of your distribution that represents net unrealized appreciation (NUA). You won’t be taxed on the NUA until you sell your stock.

What’s more, the NUA will be taxed at long-term capital gains rates which are typically lower than ordinary income tax rates. This strategy can result in significant saving.

What is net unrealized appreciation? A distribution of employer stock consists of two parts: (1) the cost basis (this is the value of the stock when it was contributed to, or purchased by your plan) and (2) any increase in value over the cost basis until the date the stock is distributed to you. This increase in value over basis, fixed at the time the stock is distributed in-kind to you, is the NUA.

How does the NUA tax strategy work? At the time you receive a lump sum distribution that includes employer stock you’ll pay ordinary income tax only on the cost basis in the employer securities. You won’t pay tax on the NUA until you sell the securities. At that time the NUA is taxed at long-term capital gains rates, no matter how long you’ve held the securities outside the plan (even if only a single say).

Any appreciation at the time of sale in excess of your NUA is taxed as either short-term or long-term capital gain, depending on how long you’ve held the stock outside the plan.

For example, you receive a lump sum distribution from your 401(k) plan consisting of $100,000 of employer stock. The cost basis is $50,000. You are taxed on the cost basis of $50,000 as ordinary income.

There is also $50,000 of UNA as the value of the stock was $100,000. If you sell the stock a year later for $100,000, you will owe capital gains tax on the $50,000 profit.

If your distribution includes cash in addition to stock, you can either roll the cash over into an IRA or take it as taxable distribution. And you don’t have to use the NUA strategy for all employer stock. You can roll a portion into an IRA and apply NUA treatment to the rest.

What is a lump sum distribution? In general you’re only allowed to use these favorable NUA tax rules if you receive the employer securities as part of a lump sum distribution.

To qualify as a lump sum distribution, it must be a distribution of the entire balance, within a single tax year, from all your employer’s qualified plans of the same type (that is, all pension, profit sharing, or stock bonus plans). Also, the distribution must be paid after you reach 59½, or as a result of your separation from service, or after your death.

There is one exception. Even if your distribution doesn’t qualify as a lump sum, any securities distributed from the plan that were purchased with your after tax (non-Roth) contributions will be eligible for NUA tax treatment.

NUA is for beneficiaries and heirs: If you die while you still hold employer securities in your retirement plan, your plan beneficiary can also use the NUA tax strategy if he /she receives a lump sum distribution.

The taxation is generally the same as if you had received the distribution. (The stock doesn’t receive step-up in basis, though).

If you’ve already received a distribution of employer stock, elected the NUA tax treatment, and die before you sell the stock, your heirs will have to pay long-term capital gains on the NUA when he or she sells the stock. However, any appreciation as of the date of death in excess of the NUA will forever escape taxation because, in this case, this tock will receive a step up in basis.

When is NUA treatment the best choice? In general, the NUAS strategy makes the most sense for individuals who have a large amount of NUA and a relatively small cost basis. However, what is right for you depends on many variables. It is best to consult your financial advisor and tax consultant to determine what is best for you.

If you have questions, call Doug Awad at 854-6866, or e-mail Doug.Awad@raymondjeames.com. He is a resident on the 200 Corridor and his office is on 31st Road, adjacent to Paddock Mall.

This information was partially developed by Forefield. Inc., an independent third party It is general in nature, is not a complete statement of all information necessary for making an investment decision, and is not a recommendation to buy or sell any security.

Investment6s and strategies mentioned may not be suitable for all investors. Past performance may not be indicative of future results. Raymond James & Associates, Inc. does not provide advice on tax, legal, or mortgage issues. These matters should be discussed with an appropriate professional.