Today’s article is the start of another mini-series. I did one before and the responses were positive, so I thought I would do another one. Plus, this is a great way for me dive deeper into an equity compensation-related topic. These are rather complex topics and my choices are either to do a super long post or break the topic into manageable parts. You know my philosophy is to keep short. Why? Because as a child of the 80s, I learned everything can be solved in the time of a sitcom episode.
Enough of that. I know I covered the generalities of what is Net Unrealized Appreciation in another post. Today we are going to dive a bit deeper into this topic in what will be the first part of this mini-series. I apologize ahead of time of anything is repetitive. I know there will be parts, but the goal is to get into new territory.
Final comment before we jump into the NUA mini-series. NUA is an advanced financial planning technique. It also easily falls into the world of advanced tax planning, but I’m stating here it has more to do with financial planning since there are so many moving parts and it is almost entirely related to someone retiring. My point is – if you are considering whether to go the NUA route, be sure to talk to a Certified Financial Planner who knows the ins and outs of NUA. This is too complex for you to be a guinea pig for a CFP who has never done one before. If it goes wrong, well, you both learn something. Unfortunately, it may be much more costly for one party vs the other.
RETIREMENT DISTRIBUTION OPTIONS
As we enter into this discussion, I want to give a big shout out to Jeffrey Levine. He did a wonderful CE webinar some time ago on the subject. It was a great resource as I prepared for this mini-series.
Now, when you retire you have a handful of options of how to get your funds out of your workplace retirement accounts. I won’t cover them all, but there are two key ones to mention as we discuss NUA. The first is the rollover to an IRA. The next is a lump sum.
Not to presume anything, IRA stands for Individual Retirement Account. The Rollover IRA is when you roll the balance from your workplace retirement plan to your personal IRA. There are more specific reasons why it is called a Rollover IRA, but they aren’t important here. The important thing is by rolling over your workplace plan directly to your Rollover IRA you continue to avoid paying taxes. Once you take money out of it the funds are treated as Ordinary Income since they have never been taxed before.
The Rollover IRA is one of the first things they teach you about as a new financial advisor. It is a great way to handle your retirement funds now that you are no longer employed and also maintain the tax-deferred state of the balance. I don’t have any data to back this assumption up, but I wouldn’t be surprised if the Rollover IRA is the most popular way to access retirement funds.
However, when it comes to the NUA, it can be a huge problem. I promise to revisit why it is a problem soon.
The other option I mentioned is a lump sum. If the Rollover IRA is effective, well, the lump sum may be the worst in many situations. Why? Good question. Simply, because if you take the funds out as a lump sum they are all taxable at Ordinary Income. Let’s do a quick example. You make $100,000 and have tax-deferred retirement funds of $80,000 in an old job’s 401k. If you do the lump sum, you now have your regular $100,000 and then another $80,000 of income from the lump sum since it has never been taxed. So, Uncle Sam and the IRS are very happy because you will be paying taxes on $180,000. Even though this is a bad option in many cases, data shows 30% of distributions from retirement accounts are taken as lump sums.
WHEN THE LUMP SUM MAKES SENSE
Although I just said lump sums rarely make sense, this is what you need to do with an NUA. Yes, the NUA is basically a lump sum distribution from your retirement account. I’m just going to call it from your 401k to keep things simple.
BUT, and this is a big but, the NUA is for highly appreciated company stock. It is NOT for your regular old 401k that is in a variety of non-company stock investments and that has done well. No, NUAs are specifically for company stock.
If you don’t have company stock or you do but it isn’t highly appreciated, you are reading the wrong post my friend. To quote a client, his company stock is classified as “pooper” stock in that it never moves in price. For him, an NUA may not make sense because there is no appreciation.
If your company stock in a tax-deferred retirement plan is highly appreciated, NUA allows you to do a lump sum and instead of recognizing Ordinary Income on everything, you get to recognize the basis as Ordinary Income and the appreciation comes out as Long Term Capital Gains.
As a refresher, if you are wondering what the big deal here is, well the top tax rate for Ordinary Income is 37% and the top for Capital Gains is 20%.
Let’s look at a quick example here. You have $1,000,000 in company stock in a qualified retirement plan through work. It has never been taxed. The company contributed $200,000 of stock and the stock has done well over your career growing by another $800,000.
If you did a normal lump sum you may now have $1,000,000 subject to a marginal tax rate of 37%. And possibly another 3.8% for Medicare surcharge. To keep things simple, you end up potentially paying out over $400,000 in taxes.
With the NUA, the basis of $200,000 would end up paying out $74,000 in taxes at the highest end of 37%. The $800,000 of appreciation is taxed at 20% so $160,000 here in taxes. This brings your total to $234,000. This is much better than over $400,000 in taxes. You may have noticed I did not mention a Medicare Surcharge. This additional tax of 3.8% does not apply to NUA. How’s that for a nice surprise!
Again, this is a super simple example. In reality it is more complex which is why you need someone who caters to this world. However, I wanted to be able to share a simple comparison.
This seems like a good place to stop in this first part of the NUA mini-series. Next time we will talk a bit more about when to use and not to use NUA plus also some of the basic rules.
In today’s flashback section I am going to also continue a topic I talked about previously. The world’s greatest summer job. Yes, we are heading back to Cedar Point. Specifically, the Cedar Point and Lake Erie Railroad. You probably did not know that is the official name of this ride. And, yes, it is a ride. My sons make fun of it being a “ride” but it was the most popular ride when I worked there. To be fair, it was considered the most popular because it had the most riders every season. In reality, I am not sure how many people say that is their favorite ride at Cedar Point. Although my mom’s favorite ride was Derby Downs. You know, the racing carousel.
I shared the story previously about trying to make songs with the steam whistle and how an engineer and I were almost fired. Well, that engineer and I had another funny story. We actually had a few other stories, but this one’s safe to share.
Now, my memory isn’t 100%, but I am sharing it as how I remember it. As some background the area of the park I worked in had a group party one night. This party was at a local park and was a way for us all to get together outside of work. There was food and beverages, but nothing crazy. Just hanging out at a local park shelter.
A few days later I was working with this engineer and was looking at some pictures someone else on the train took at the party. As we were going around the loop the train took he decided to look at the photos. Now, to operate the train you had to pay attention and always have a hand on things. Literally. So I would hand him a photo, he would look at it, and then hand it back. One photo he apparently needed more sunlight to study it in greater detail. So, he put it just outside the window of the locomotive (that’s the official name for the front of the train). Unfortunately, he did not have a good hold of the photo and it flew out of his hand. He was pretty bummed as it was someone else’s photo so he decided right then on a plan to get it back.
Now, common sense would say just to walk along the train tracks after his shift and pick up the photo. There isn’t a whole lot of common sense when it comes to college-age males. Instead, on our next pass he kept an eye out for it and then suddenly told me to take over. He hopped off the train, waited for the train to pass, leaned down to pick up the photo, and then hauled ass to catch back up to the locomotive.
If you could have seen the looks on the faces of the riders. It was hysterical. Now, I was trained to be able to start and stop the train in case of emergencies. Again, I was technically a fireman and threw coal into the fire. The few stops and starts I had done were rather ugly. And when I say ugly I mean they were jarring to anyone riding the train. Fortunately, he jumped back on the train, made a nice stop once we came into the station, returned the photo to the stack, and no one was harmed. Oh, bonus point. The conductor rode on the back of the train. She had to be thinking “what is this engineer doing” when he jumped off the train and let it pass by. See. Greatest summer job ever.
As always, thanks for taking the time to read this. Please do not hesitate to reach out if I can be of help with your equity compensation-related questions. The easiest thing to do is to click the little green box that reads “Schedule a Meeting” that can be found at the bottom of every page on my website. Or, just click my Calendly link right here.
I’m Dan Johnson, CFP®, founder of Forward Thinking Wealth Management. I run a flat-fee financial planning and investment management firm located in beautiful Akron, OH. Although I am in Akron, OH, I work with clients regardless of location. I cater to owners of equity compensation positions who are looking to organize their financial lives, keep more of what they make, and do the things they want in retirement and even now.