Kitces: Net Unrealized Appreciation (NUA) Tax Strategies for Modestly Appreciated Stock (September 29, 2021)

Kitces has made available for download their article, “Net Unrealized Appreciation (NUA) Tax Strategies for Modestly Appreciated Stock”, published on Kitces. The Executive Summary is as follows:

While pre-tax distributions from retirement accounts are generally taxed at ordinary income rates, an exception to this rule applies to appreciated employer securities distributed from an employer plan that are a part of a Net Unrealized Appreciation (NUA) transaction. In such instances, the NUA (i.e., the appreciation on the employer securities that occurred within the employer’s retirement plan) is taxed at the more favorable long-term capital gains rates (when sold in a taxable account).

Given the disparity between the two rates, the ability to swap ordinary income tax rates for long-term capital gains tax rates on a portion of a worker’s retirement savings may sound highly appealing. However, doing so is not always a great move. While the NUA itself gets the benefit of long-term capital gains treatment, the portion of the shares distributed that is attributable to their cost when purchased within the employer plan (what would be their basis had they been purchased with taxable dollars) is subject to ordinary income tax rates right away. Additionally, completing an NUA transaction removes the assets (for which NUA is used) from the ‘protective’ tax-deferred wrapper provided by a retirement account.

Nevertheless, there are clearly times when an NUA transaction can be used to help reduce an individual’s tax liability. But to do so, three key NUA rules must be followed:

NUA transactions can only be made after a ‘Triggering Event’;

The employer-sponsored retirement plan must be emptied within one calendar year (i.e., as a lump-sum distribution); and

The shares of stock on which NUA is desired must be moved, in-kind, to a taxable account.

Since the favorable long-term capital gains treatment in an NUA transaction is only applicable to the growth of the employer securities (while the purchase price of the shares is subject to ordinary income tax), the strategy is generally viewed as one that is best reserved for employer securities that have experienced substantial growth. Indeed, the greater the appreciation, the more attractive NUA becomes. Even so, that doesn’t mean that NUA can’t be useful in other situations.

One situation in which NUA with more modestly appreciated employer securities can make sense is when the NUA transaction is used to fund near-term cash flow needs. If a plan participant needs to take a distribution from their plan to satisfy immediate cash flow needs, then absent the use of NUA, the entire distribution will be taxed at ordinary income rates. By contrast, as long as there is at least some level of appreciation in the employer stock in the plan (i.e., some amount of NUA), then using an NUA transaction to fund short-term cash needs will result in a tax savings, as the proportion of the distribution attributable to growth (versus the purchase price) will be taxed at long-term capital gains rates.

Just how ‘short-term’ the cash flow need should be for NUA with modestly appreciated securities to make sense depends on the situation, which should be evaluated based on a taxpayer’s unique set of facts and circumstances. If a taxpayer can fund multiple years of cash flow needs using NUA, without pushing themselves into a higher tax bracket, then such a move is likely to make sense. By contrast, where (a significant portion of) the added ordinary income created by an NUA transaction is taxed at a higher marginal rate than would otherwise be the case if ‘regular’ distributions were spread of those years, the benefit of the long-term capital gains tax treatment on the NUA is often more than offset by the higher ordinary rates that apply to the cost of the shares.

Ultimately, Net Unrealized Appreciation (NUA) can provide certain plan participants with valuable tax-saving opportunities. And while using NUA with modestly appreciated employer securities to fund short-term cash flow needs isn’t likely to be the ‘move’ that makes or breaks one’s retirement success, it’s a relatively easy way for many plan participants to reduce their tax bill. And when it comes to taxes, less is always more!

To read the full report, click: “Net Unrealized Appreciation (NUA) Tax Strategies for Modestly Appreciated Stock”

Posted by Marin Larkin, Associate Editor, Wealth Strategies Journal.

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