You changed jobs. You have funds in your ex-employer's retirement plan that includes some employer's stock. What should you do? Roll the funds tax-free to an individual retirement account? This may not be the best move in all cases, especially not if your employer stock has appreciated significantly.
Thanks to an often overlooked tax concept called "net unrealized appreciation" (NUA), here is a strategy that could be financially more beneficial to you: Instead of rolling over to an IRA, take an in-kind distribution of the stock. In other words, move the stock into a taxable account owned by you without converting into cash first. Let the investment grow tax-free, and reap significant tax benefits in the long run.
It is important to note that this strategy forces you to pay taxes and penalties up front. So, whether the approach is right for you depends on several factors such as your age, how much the stock has appreciated, your anticipated tax rates and the future performance of the stock.
With those caveats in mind, let us discuss four characteristics of such strategy
1. Taxes and penalties are limited to the cost basis of the stock.
When you receive a distribution from your employer's retirement plan, you will generally be required to pay income taxes on the amount distributed. Moreover, if the distribution is made before you are age 59½, you are likely to pay an additional 10% penalty on the withdrawal. However, if the distribution involves employer's stock and qualifies for NUA treatment (refer to IRS Publication 575 for details on qualification rules), the tax and penalties are limited to the cost basis of the stock, not for the full market value of the stock.
For example, let's say your ex-employer's stock in the retirement plan is worth $100,000 currently. Assuming your cost for the stock when you or your employer contributed to the plan was $10,000, if you take an in-kind distribution of the stock, you will pay income taxes and penalties only on the cost basis of $10,000, not on the current market value of $100,000.
2. Taxes on the appreciation are deferred.
By definition, NUA refers to the amount an employer's stock appreciates while inside the retirement plan. In other words, NUA is the difference between the cost of the stock when you or your employer contributed to the plan and the market value of the stock when you take a distribution. So, in the above example, the NUA is $90,000.
The IRS allows you to defer income taxes on this NUA until you ultimately sell the stock. Appreciation of the stock in the taxable account is tax-deferred as long as you own the stock, as well.
3. Preferential capital gains rates apply when you sell the stock.
When you ultimately choose to sell the stock, even if it's just one day after taking the in-kind distribution, the entire NUA is treated as a long-term capital gain and receives preferential treatment. (Any appreciation generated after taking the distribution will be taxed at preferential capital gains rates if held for more than a year.) Current tax code allows tax rates on long-term capital gains that are significantly lower than on ordinary income. For example, taxpayers in the 10% and 15% tax brackets pay no tax on long-term gains; taxpayers in the 25%, 28%, 33% and 35% income tax brackets face a 15% rate; and, those in the top 39.6%, pay 20%.
Continuing with the above example, let us say, five years after taking the distribution, your stock is worth $200,000. If you sell the stock at that point, you owe preferential capital gains rates on the $190,000 appreciation ($90,000 NUA plus $100,000 long-term gains after the distribution). By comparison, if you had rolled the stock into an IRA and taken a distribution from the IRA after you retire, you would have paid ordinary income taxes on the entire $200,000. Do you see the benefit?
4. Heirs get a step up in basis.
Finally, if you do not sell the stock during your lifetime, and leave the NUA stock as an inheritance to your heirs, they could get significant tax advantages, as well. While your heirs are still required to pay long-term capital gains taxes on the NUA portion of the appreciation, they do get a step up in basis for the appreciation after the date of distribution.
Going back to our example, if the distributed stock is worth $500,000 when it is passed to the heirs, your heirs are required to pay long-term capital gains only on the $90,000 NUA. The $400,000 gain after taking the distribution comes tax-free!
So, if you have appreciated employer stock in your qualified plan, do your due diligence and consult your adviser to find out if you could indeed benefit from this strategy. Good luck!
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