The Net Unrealized Appreciation (NUA) technique can save you taxes!
FACTS & BACKGROUND:
• Jack has worked for the same company for many years; He has accumulated a large position of his employer’s stock in his qualified retirement plan (401K or ESOP). His loyalty to the company is evident by his conviction “This is the stock that made me rich.”
• The single company’s stock makes up a large percentage of his overall net worth
• Jack’s cost-basis in the stock is very low – since he was able to purchase at low average costs over many years, while the stock value appreciated over that time
• Jack is retiring soon, and must decide what to do with his company retirement plan
DILEMMA:
• Jack’s retirement account lacks diversification – his portfolio presents high single-stock risk
• Jack will soon depend on consistent cash withdrawals from his account to fund his retirement lifestyle
• Jack received complex paperwork from his employer’s personnel department to indicate his preference for transferring his company retirement plan assets
INNOVATIVE STRATEGY:
To increase the likelihood of achieving Jack’s retirement income goals, prudence dictates reducing the risk of having all his “nest eggs in one basket.” (Witness the outdated idea that any one company is “too big to fail.”)
Jack’s financial advisor carefully follows all of the strict rules outlined in the Internal Revenue Code to take advantage of special NUA tax election.
• Electing lump sum, Jack receives an in-kind distribution of the company’s stock from his retirement account
• Only the remaining non-company securities are rolled over into an IRA account
• Jack pays income tax only on the original cost-basis portion of his company stock
• The remaining “net unrealized appreciation” on the company stock is not taxed until it is sold. And it qualifies for long-term capital gain treatment – regardless of how soon Jack liquidates the stock for diversification into other investment opportunities
• Since most of the value was immediately distributed in-kind, the lesser dollar amount transferred into his IRA reduces future RMDs, and thus reduces ordinary income taxes on future distributions
This strategy works best under these circumstances:
• Significant difference between the retiree’s ordinary income tax rate and long-term capital gains tax rate
• Large absolute dollar amount of NUA versus non-NUA securities – due to difference in tax rates applied
• Significant appreciation has occurred on the NUA assets – more dollars are eligible for lower tax rates
• When the NUA assets are expected to be liquidated for cash flows sooner than later (the tradeoff for continued deferral of growth in an IRA)
Since the NUA tax treatment is not available to IRAs, care must be taken to avoid rolling the employer’s stock into an IRA. Once done, the tax break is lost forever – since the election is irrevocable.
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