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Lord Abbett Weighs in on Appreciating Net Unrealized Appreciation

Posted by WrapManager's Investment Policy Committee
May 3, 2018

Lord_Abbett_Market_CommentaryNet unrealized appreciation allows for favorable tax treatment of withdrawals of an employer's stock - but understanding the rules is crucial.

Of all the various ways to reduce one’s taxes in retirement, net unrealized appreciation (NUA) is often misunderstood or overlooked altogether. The rules may be complicated, but a plan participant who owns company stock and is separating from service or retiring should be aware of NUA before rolling his/her retirement account into an IRA or a new employer’s plan.

Net unrealized appreciation of employer stock held in an employer-sponsored retirement plan permits gains that occurred inside the plan to be taxed outside the plan (e.g., brokerage account) at preferential long-term capital gains rates.

NUA defined is the increase in the value of the employer stock from the time it was acquired by a plan (its cost basis) to the date of the distribution to an employee. As such, he or she can elect to defer the tax on the NUA until the stock is sold. When sold, the retirement investor will pay tax only at his/her current capital-gains rate.

Thus, NUA creates an opportunity to convert unrealized gains from ordinary individual income rates into lower long-term capital gains rates instead. However, there is a requirement that in order to be eligible for NUA treatment, the account owner must report the stock cost basis immediately subjected to immediate income tax–paying taxes at ordinary income tax rates.

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Consider the example of a 401(k) participant who owns 100 shares of company stock with a cost basis of $10. Upon retirement the stock has increased in price and is now valued at $25 per share. The participants’ cost basis is $1,000, the price originally paid, while the NUA is $1,500—the worth of the stock appreciation since the purchase price.

Generally, qualified plan distributions are subject to ordinary income tax on the fair market value upon withdrawal, unless the cash value is rolled over into a tax-advantaged account, such as a traditional IRA. When a distribution from a qualified plan includes employer securities, the same rule applies unless the NUA provision is applied to the stock holdings.

Net unrealized appreciation offers retirement investors receiving an in-kind distribution of employer’s stock from their plan a tax break by assessing income taxes only on the cost basis. Later, when the stock is sold, the NUA is taxed at long-term capital gains rates, which tend to be lower than federal income tax rates. The maximum rate of that tax currently is 37%, compared to the maximum capital gains tax rate of 20%, or 23.8% for those higher-earners who qualify for the 3.8% Medicare surtax on net investment income. Either way, the potential savings is substantial.

NUA Requirements

Satisfying the myriad of NUA requirements, there are very specific requirements that must strictly adhered to.

In order to qualify for the NUA tax break, the Internal Revenue Code rules under Section 402(e)(4) are clear: distribution (of employer stock) must be distributed in-kind, as a lump-sum distribution after a triggering event. Events that qualify for NUA include death; age 59½ (plan must allow); separation from service (not for self-employed); retirement; or disability (self-employed only).

Share basis will be immediately taxed as ordinary income however the stock gains will be taxable at long-term capital gains rates regardless of the actual holding period.

Tip: If the appreciated company stock is rolled over to an IRA, the NUA tax break is lost, and any IRA distribution will be taxed as ordinary income.

What’s a Lump-sum Distribution?

An individual’s entire account balance must be distributed in a single tax year. This doesn’t just mean all the stock must be taken out of the plan; it means the entire account must be distributed including non-stock assets (e.g. mutual funds).

Tip: IRS rules permit an individual to facilitate an NUA distribution for just part of their account, and roll over the rest directly to a traditional IRA. However, account assets must be zero at the end of the year.

Download Lord Abbett's article "Appreciating Net Unrealized Appreciation" to learn when NUA may be advantageous.

To learn more about Lord Abbett & Company's investment style, request a report on their investment style, management and history here. 

 

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The information presented by WrapManager, Inc. is general information only and does not represent tax or legal advice, either expressed or implied. You are encouraged to seek professional tax advice for income tax questions and assistance. WrapManager, Inc. does not advise on any income tax requirements or issues.

This material is not intended to be relied on as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The information presented is general information that does not take into account your individual circumstances, financial situation or needs, nor does it present a personalized recommendation to you. The information and opinions contained in this material are derived from sources deemed reliable, are not all-inclusive and are not guaranteed as to accuracy.

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