WAIT! Don't Roll That 401k Just Yet

To all retirees or recent job changers thinking about rolling their old 401k money out to a rollover IRA pay close attention; you may be able to save a whole lot in taxes!! How? By using what is called the Net Unrealized Appreciation (NUA) strategy. Let's review:

What is the NUA strategy?

• It is a strategy that utilizes special tax treatment to help retirement plan participants who receive a lump-sum distribution that includes company stock to lower their taxes as low as 15% on that distribution. It is a means by which to trade ordinary income taxation on a portion of retirement assets for long-term capital gains treatment.

Who can benefit from the strategy?

• Anyone holding employer securities (i.e. stock) in a qualified retirement plan (such as Employee Stock Ownership Plans (ESOPs), 401ks, cash balance, profit sharing, etc.). Note: This strategy especially benefits those with highly appreciated company stock.

How does the NUA strategy work?

• Assets in your employer-sponsored plan, including company stock, accumulate on a tax-deferred basis. Once you begin taking distributions from the employer sponsored plan or the rollover IRA set up to roll the plan into, you generally must pay ordinary income tax on the current market value of the assets distributed in-kind, plus any cash distributed (if you sell the mutual fund, stock, etc. before distributing it from the plan).
• However, assuming your plan allows it, using the NUA strategy allows you to pay the capital gains tax rate rather than the ordinary income tax rate on the portion of your lump-sum distribution consisting of appreciated company stock.
• Under the NUA strategy the original basis (i.e. contributions to the plan) is immediately taxed as ordinary income. It is the remaining value, the Net Unrealized Appreciation that is taxed at long-term capital gains rates.
• A lump-sum distribution is a payout within one taxable year of your entire balance from all of your qualified plans of one kind (e.g., pension, profit-sharing, stock bonus) from a particular employer.

How to execute the NUA strategy:

• Request that your retirement plan administrator distribute the shares of your employer stock to a taxable account. At that time you must pay ordinary income tax on the average cost of the stock. Note: The original basis is subject to a 10% penalty unless you are age 55 or over and separated from employer service.
• The average cost, (also referred to as the cost basis), is the average of the individual values of employer stock when each share was contributed to the plan (either by you or the company).
• You are not required to pay taxes on the NUA at the time of distribution to your personal account, but you must pay capital gains taxes on that amount when you sell the shares.
• If you decide not to sell the stock immediately upon distribution to your personal account, the share price may change between the time you take the distribution and the time you sell the shares. If the price increases, that additional appreciation is taxed either as a long-term or a short-term capital gain, depending on how long you hold the shares after distribution (i.e. 1 year or longer for long-term capital gains).
• Other pension assets, including mutual funds (or the cash proceeds from their sale) may be rolled over into a traditional IRA to maintain tax-deferred growth.

Many times the easiest way to explain a complex strategy is to give a specific example. For instance, assume in the following the individual in question is a 60 year old retiring corporate executive with qualified plan employer stock with a current value of $1 million and a basis of $75,000. The executive is in the top marginal tax bracket (35%) and is expected to stay in the same bracket in retirement. The executive's other taxable portfolios are fully diversified.

1. Scenario 1: Roll stock over into an IRA and hold for 10 years with an 8% growth rate.
2. Scenario 2: Elect NUA and hold the stock in a personal account with an 8% growth rate. (Note: Assumes 15% long-term capital gains and dividend tax rates enacted in 2003 remain in force and that the basis is not subject to the 10% premature distribution penalty discussed above.)
3. Scenario 3: Elect NUA, sell the stock immediately and reinvest in a mutual fund with a total growth rate of 8% consisting of 25% qualified dividends taxed at 15%, 37.5% long-term capital gains taxed at 15% and 37.5% short-term capital gains taxed at 35%. (Note: Assumes 15% long-term capital gains and dividend tax rates enacted in 2003 remain in force and that the basis is not subject to the 10% premature distribution penalty discussed above.)

Recap:

1. Scenario 1: Roll stock over into IRA
2. Scenario 2: Elect NUA; hold stock for 10 years. Incremental benefit: $383,614
3. Scenario 3: Elect NUA; sell stock; reinvest proceeds in diversified portfolio. Incremental benefit: $107,167

Other Issues to Consider
If you decide to place your company stock (Scenario 1) or the proceeds from the sale of the company stock (Scenario 3) in a taxable account remember:

1. You must elect lump sum, in-kind distribution from the qualified plan and the total distribution of all assets must occur in a single calendar year.
2. Assets outside a qualified employer plan or IRA may have less protection from creditors' claims.
3. The stock price could decline or tax rates could change, defeating the tax-saving benefits of the NUA strategy.
4. The NUA strategy is less beneficial if your tax rate is likely to decline in retirement.
5. State income taxes also should be considered.
6. Effect on beneficiaries: The NUA strategy can benefit your beneficiaries if you hold the stock in a taxable account and it appreciates before your death. When your beneficiaries sell the stock they inherit, they will owe long-term capital gains tax on the unrealized appreciation (the unrealized appreciation in the 3 scenarios is $925,000 ($1,000,000 - $75,000). This is the same tax you would owe if you sold the shares yourself.
7. Effect on beneficiaries continued: Any additional appreciation between the date of distribution and the date of your death is never taxed. That amount is treated as a "step-up" in cost basis for your beneficiaries. In Scenario 2 this amounts to $1,128,503 ($2,102,253 - $973,750) that is never taxed!!!

In summary, although the NUA strategy is not well known or understood by most financial advisors or the general public, it can be a powerful tax savings tool for both yourself and your beneficiaries. Remember though, you should never let the tax tail wag the investment dog; diversification in your portfolio is critical.

This information is general in nature and should not be construed as tax advice. Please keep in mind that Cypress Advisory Services does not offer tax advice. Please consult your tax advisor for guidance on your particular situation.