Cash In on the Unique NUA Tax Break

Benefits of company stock in retirement plans

One frequent tax reform target is still on the books. It is a unique tax break available to employees, including business owners, who own company stock in their retirement plan. If you handle things right, you can avoid paying tax on the appreciation in the stock’s value, called the net unrealized appreciation (NUA) when you receive a distribution, as well as realizing favorable capital gain rates on a sale.

But do not put all your eggs in one basket. Make sure your retirement account is properly diversified, utilizing other assets in addition to stock in your company. Nevertheless, the tax benefits for this technique cannot be disputed.

Background: If you receive a retirement plan payout in the form of company stock, you pay tax only on the original cost of the stock. No tax is due on the NUA. Furthermore, any subsequent gain on the NUA is treated as long-term capital gain if you have held the stock for more than one year.

But this tax treatment is not automatic. To qualify for these breaks, a distribution must meet all of the following three requirements:

  • The distribution must come from a qualified retirement plan, such as a 401(k), pension or profit-sharing, or stock bonus plan.
  • The distribution must be due to your having reached the age of 59½, death or separation from service.
  • The distribution must be made in one tax year.

Currently, the maximum tax rate on long-term capital gain for most taxpayers is 15%, or 20% if you are in the top ordinary tax bracket of 39.6%. At the top tax rate, it is a differential of 19.6%.

Perhaps the best way to illustrate the tax savings is to look at a hypothetical example.

Simplified facts: You have acquired 20,000 shares of company stock in your 401(k) over the years. The shares are currently worth $1 million. Originally, the stock cost $5 a share, but now it is valued at $50 a share.

If you sell the stock inside the plan and then take a cash distribution, you will receive $1 million. However, the entire distribution will be taxed as ordinary income. If you are in the 39.6% tax bracket in your year of retirement, you will owe federal income tax of $396,000 (39.6% of $1 million). Conversely, if you take the distribution in the form of company stock, you are taxed on the original cost of $100,000 (20,000 shares at $5 a share). Result: Your federal income tax bill is only $39,600.

Suppose you immediately sell the stock at $50 a share for a total of $1 million. Assuming your entire $900,000 gain is taxed as long-term capital gain at the 20% rate, you must pay $180,000 in capital gains tax (20% of $900,000). Therefore, your total federal income tax bill is $219,600 ($39,600 + $180,000), a tax savings of $176,400 ($396,000 – $219,600). Note that other tax factors, including the 3.8% net investment income tax and state and local taxes, may also come into play.

Conclusion: It remains to be seen whether this tax break will survive much longer. This may be an opportune time to take advantage of NUA. Consult your professional advisers.

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