Is your retirement plan invested in your employer's company stock? If so, there is a tax strategy available to you that is often overlooked.
Normally, all withdrawals from a retirement plan are taxed as ordinary income, at ordinary income tax rates. However, if you take distribution of your employer's company stock from your retirement plan and hold it in a taxable investment account, you may be able to significantly reduce taxes on plan distributions. This strategy is called the Net Unrealized Appreciation ("NUA") approach. It is authorized by Section 402(e)4 of the Internal Revenue Code.
NUA is the difference between the cost basis of the stock inside the plan and the stock's current market price on the distribution date. Using the NUA approach, only the cost basis of shares is subject to tax at the time of the distribution from the qualified plan. The difference between the basis and the fair market value--the net unrealized appreciation--is taxed at long-term capital gains rates only when the stock is sold, regardless of the holding period. This can be a better result than rolling the stock into an IRA where all of its value will eventually be taxed as ordinary income when it is distributed to you or to your beneficiaries.
When the stock is sold, NUA is treated as a long-term capital gain, even if it is sold immediately after distribution. Any appreciation of the employer stock that occurs after it is distributed will be considered a short-term capital gain if the employer stock is held for less than one year. If the stock is held for at least one year after the transfer, it is then characterized as a long-term capital gain.
If you never sell the shares of stock with the NUA, when your beneficiaries sell the stock they inherit, they will owe long-term capital gain tax on the unrealized appreciation portion of any gain. However, since the stock receives step-up in cost basis on your death, any additional appreciation between the date of distribution and the date of your death is never subjected to income tax.
If you take the NUA approach, the shares of company stock are outside the plan and not in an IRA. They are in a regular investment account. There are no minimum distribution requirements. The higher your income tax bracket and the more the stock has appreciated, the more you may benefit from this strategy.
If you are considering this technique, ask your plan administrator for the cost basis of various lots of employer stock in your plan. It makes sense to take out shares with the lowest cost basis. You don't have to take out all the shares. You can rollover part of the shares - choosing the ones with a higher cost basis to rollover. The special NUA treatment is lost for shares that are rolled over into an IRA.
Unfortunately, many retirees and advisors assume that rolling a retirement plan distribution into an IRA is the only option available. On the surface, this seems like the standard operating procedure, but it could cost thousands of dollars in additional taxes that could have been avoided.
In order to use the NUA approach, the employee must elect a lump-sum, in-kind distribution from the plan (a complete distribution of all plan assets in a single calendar year). A lump-sum distribution can be received on the employee's death, on the employee's attaining age 59 l/2, on the employee's separation from service, or on the employee's becoming disabled. If there is company stock in your retirement plan when you die - your spouse or other beneficiaries can use the NUA strategy.
With capital gains rate at an historical low, the increased use of company stock in retirement plans, and the long-term gains of the stock market, using the NU approach makes good sense for many plan participants.