By Ben Abitz
If you own highly appreciated stock in your company’s qualified retirement plan 2021 could be the perfect setting for you to utilize net unrealized appreciation strategy, or NUA. NUA will only work for certain situations, and you will want to coordinate with your financial professional, tax advisors and employer to be sure you check all the boxes. The tax savings can be substantial so it is worth looking into if you believe you may be a candidate. The process, outlined in Section 402 of the Internal Revenue Code and further clarified in Revenue Ruling 81-122,1981-1 C.B. 202, allows favorable tax treatment of employer stock.
What Does That Mean?
You can split up your tax burden on your employer stock into two sections. The cost of the original share purchase or basis are taxed as ordinary income rates. However, the gains in the employer stock get taxed at much lower long term capital gains rates.
Mike has 2,000 shares of ABC company stock in his 401k plan. ABC stock is currently $200 per share. The average price per share when they were bought (cost basis) was $25 per share. In an NUA, the shares would be transferred in-kind (meaning the shares aren’t sold) to a taxable investment account. The cost basis of $50,000 ($25 x 2000 shares) would be taxed as ordinary income in that year. The remaining $175 of value in the shares would be taxed at long-term capital gains rates when they are sold, effective immediately after the transfer. In this scenario we illustrated Mike in the highest tax bracket, he would pay $18,500 ($50,000 x 37%) in federal taxes on income, and $70,000 in Capital Gains Taxes ($175 x 2000 shares x 20%) if he sold the shares immediately. Using NUA Mike would pay a total of $88,500 of tax liability. If Mike did not use the NUA strategy, he would pay $148,000 ($400,000 x 37%) when distributing these shares. By using the NUA strategy, Mike is able to lower his tax burden by $59,500 in this example.
Why Is This So Relevant?
Income and Capital Gains Rates are currently at historically low rates and are expected to rise. Moreover, The larger the difference between Income Tax Rates and Capital Gains Rates the more effective an NUA strategy would be. This chart from the Tax Policy Center, gives us a visualization since 1954.1 Proposed legislation from the White House looks to introduce higher income and capital gains rates both at the highest rate to 39.6% on earners over $1 million annually. Let’s look back at Mike to see how this would affect his situation.2
Under the proposed tax changes, in the top brackets, NUA would actually be harmful. This is the case because it would eliminate the tax deferred growth while the shares are kept within the retirement plan. Without beneficial capital gains rates, Mike would pay the new proposed 39.6% on the $400,000 worth of ABC stock.3 If this legislation passes, Mike would be facing $158,400 of tax liability without the option of an NUA.
With the strength in the stock market, historically low tax rates rumored to rise, 2021 maybe the NUA perfect storm. If you would like us to review
your situation and chat to see if this strategy may make sense for you send us an email or call us at 336-540- 9700 and we would be happy to help. We can help gather the cost basis information and evaluate your NUA options. An NUA strategy can take months to implement depending on your company plan and tax advisors so please don’t hesitate. If you wait until Christmas it will likely be too late.
Ben Abitz is a Financial Planner with Matt Logan Inc and with a focus on high net-worth and complex tax strategies. His previous experience includes time with a large investment bank and a trust company managing nearly $2 billion dollars in assets.
For a comprehensive review of your personal situation, always consult with a tax or legal advisor. Neither Cetera Advisor Networks LLC nor any of its representatives may give legal or tax advice
1Rob McClelland “Capital Gains” Tax Policy Center, February 7, 2017, https://www.taxpolicycenter.org/-publications/capital-gains/full
2Garret Watson, Huaquan Li, Alex Durante and Erica York “Details and Analysis of Tax Proposals in President Biden’s American Families Plan” Tax Foundation, May 2021, https://taxfoundation.org/american-families-plan/
3Mark Zandi and Bernard Yaros, “The Macroeconomic Consequences of the American Families Plan and the Build Back Better Agenda,” Moody Analytics, May 3, 2021, https://www.moodysanalytics.com/- /media/article/2021/american-families-plan-build-back-better-agenda.pdf