If you’re in a retirement plan that lets you invest in your company’s stock, you should be aware of something called net unrealized appreciation (NUA), a simple tax reduction strategy with a complicated name.
When you withdraw your employer’s retirement plan, it’s fully taxable unless you roll it over to an IRA. An IRA is the preferred method, unless you feel patriotic and want to pay unnecessary taxes. Believe me, the government can sure use the revenue.
Down the road at some point, though, you’ll take income from your IRA. At that point, the income you take will be taxed as ordinary income at your top marginal tax bracket.
Now let’s back up a couple of steps. Say your retirement plan has company common stock in it. If so, there may be another option. You may have a shot at paying long-term capital gains rates on a portion of that common stock instead of ordinary income taxes.
Why does it matter? The top marginal tax rate is 39.6 percent. The top long-term capital gains rate is 20 percent. What rate would you rather pay? This can be huge for some of you out there.
Here’s generally how it works: You remove or withdraw – but not sell – the common stock from the employer plan. You also shouldn’t roll the common stock to an IRA. But if there is still a balance left in your company retirement plan after you withdraw the company stock, you should roll that part to an IRA.
What is net unrealized appreciation? At this point, the common stock has been withdrawn from the employer plan and is not in an IRA.
There’s then two parts to NUA: The cost basis, the amount originally put into the stock, and the growth over the cost basis up to the date the stock is withdrawn.
Let’s say you retire from your company and you receive a $500,000 distribution of your company’s stock from your 401k plan. If the cost basis in the stock is $50,000, then the NUA is $450,000.
When you withdraw the company stock, you pay ordinary income tax on the $50,000 cost basis only at your marginal bracket. You won’t pay any tax on the $450,000 NUA until you sell the stock. See how this works?
When you sell it in the future, the NUA is taxed at the more favorable long-term capital gain rates – no matter how long you’ve held the securities outside of the plan. Any appreciation at the time of sale in excess of your NUA is taxed as either short-term or long-term capital gain. It depends on how long you’ve held the stock outside the plan.
There is a warning. If IRS rules are not followed precisely, this strategy will get a wrench thrown into it. If it’s also tried at too early an age, there may be a 10 percent early withdrawal penalty.
• Mike Piershale, ChFC, is president of Piershale Financial Group. Send financial questions you want answered in this column to Piershale Financial Group , 407 Congress Parkway, Crystal Lake, or email firstname.lastname@example.org.