Net Unrealized Appreciation: Here's All You Need to Know

When you think of retirement planning, you have a gamut of options to choose from. There are many employer-sponsored retirement plans, like the 401(K) or individual retirement account (IRA) that come with a lot of benefits. The real inconvenience, however, is the fact that retirement benefits are not always exempted from taxes. Needless to say, it is imperative to adopt a strategy that lets you pay minimal tax on the lump sum return of your years of hard-work and service. One such tax-saving strategy is the Net Unrealized Appreciation (NUA), also known as the embedded capital gain.

What is Net Unrealized Appreciation (NUA)?

Net Unrealized Appreciation (NUA) is the appreciation or growth in the amount invested. It is generally related to the distribution of appreciated company stocks from an eligible employer-based retirement plan. The NUA calculation formula is quite simple,

Market Value of a Stock – Cost Price of a Stock = Net Unrealized Appreciation

Market value of a stock refers to the current selling price of the stock.
Cost price of the stock is the price you pay to buy the stock.

Net Unrealized Appreciation (NUA) stocks fall under cost basis taxation rules. It is especially important for several retirement plans like 401(K).

It is a common practice for public-owned organizations to offer company shares or securities to employees. In fact, these stocks are often part of your retirement plan. So, when you end an employment contract and withdraw your stocks, your investment automatically falls under standard income tax laws. This ultimately means that employees miss on long-term capital gains from such stocks or securities.

The income received from the tax-deferred retirement accounts is a regular income as per income tax rules. The taxation rate is also higher on these accounts than other long term capital gains. To protect senior citizens from such high tax rates, the Internal Revenue Service (IRS) has come up with a new rule – the NUA strategy. Retired individuals can now distribute their stocks under NUA to save tax. Though the scheme is not mandatory, but it can definitely benefit retirees.

How is tax calculated on NUA funds?

Normally, IRS taxes the stocks under retirement accounts like the 401(K), at market value, considering it a normal income. When you distribute stocks under the NUA tax strategy, the tax is calculated on cost basis just like ordinary income. When you decide to sell NUA stocks, they are subject to taxes on capital gains.

What are the Advantages and Disadvantages of NUA?

The NUA funds taxation rate is comparatively low. The normal income tax rate is much higher than the taxation rate on capital gains. So, when you decide to withdraw NUA stocks, you end up paying lower taxes than what you would have paid as ordinary income tax. Moreover, the 3.8% Medicare surtax is not applicable to the net investment income of NUA. The only disadvantage of NUA funds is that current taxes are applicable when employer stocks are distributed under the employee retirement plan. The stocks which fall under ordinary income tax are not charged until you decide to sell the stocks. This could take several months or years before you actually pay ordinary income tax. So, in order to get the most out of NUA funds, you should place the lowest cost basis stocks under this category. This is why you pay low taxes on NUA funds on a real-time basis.

Who is Eligible for NUA Selection?

Surprisingly, not everyone is eligible for NUA funds. You must fall under any one of the following categories to utilize the benefits of NUA.

You must be at least 59½ years old. If you apply before this age, you can face a 10%penalty. However, there are some exceptions to this age rule as well. These include,
You should be separated from the company from which you purchased or received stocks.
Self-employed individuals who suffer from complete and permanent disability can also apply early.
If the shareholder dies, the nominee or immediate family member can apply for NUA regardless of the age.

How does NUA work?

Here are the key steps in the NUA tax plan

Step 1- The owner of the company stocks or securities distributes them under NUA.

Step 2- These are kept in a non-qualified brokerage account until the owner decides to sell them.

Step 3- Cost basis taxation takes place when the owner sells these securities.

Remember that the dividends earned on NUA stocks are taxable and special tax benefits can be earned on the dividend as per the general rule.

What are the rules to opt for NUA?

Keep in mind these specific rules to get NUA benefits.

The company distributes stocks to the participant ‘in-kind’.
The distribution of entire funds of the retirement account takes place within 1 year of retirement.
Roth IRAs are not considered for NUA as they are not tax-deferred accounts.
The broker accounts are also out of scope for NUA as these are already subject to capital gains tax.
NUA is only applicable for stocks of the company in which you are employed at present or were employed at some point.
The NUA election is available only when a stock is placed in the tax-deferred account. For example, 401(K) and traditional IRA accounts.
Cash cannot be transferred out of the retirement plan. Stocks must be transferred out and kept in a taxable investment account.

Things to remember

The strategy of NUA might turn out to be helpful only when the appreciation value of the company security or stock is high. It also works better for people who do not have an immediate need for funds. Lastly, you must remember that it might be risky to invest all assets or funds from your retirement into one single security Plan.

To sum it up

NUA strategy can definitely help you to transform unrealized profits from ordinary income by paying reduced tax on long-term capital income gains. However, to get the most out of this opportunity, you must have a proper plan. It is also important to thoroughly understand federal and state tax implications before investing under NUA.

Do you need help in deciding the right amount of stocks to distribute under NUA? Consult financial advisors to understand the complexities of NUA and get help in devising the perfect tax-savings plan to suit your needs.